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1 UNITED STATES OF AMERICA + + + + + PRESIDENT'S ADVISORY PANEL ON FEDERAL TAX REFORM + + + + + FIRST MEETING MINUTES + + + + + WEDNESDAY, FEBRUARY 16, 2005 + + + + + The Panel met in the Amphitheater in the Ronald Reagan International Trade Center, 1300 Pennsylvania Avenue, N.W., Washington, D.C., at 10:00 a.m., Connie Mack, Chairman, presiding. PRESENT: THE HON. CONNIE MACK Chairman THE HON. JOHN BREAUX Vice Chairman THE HON. WILLIAM E. FRENZEL Panel Member ELIZABETH GARRETT Panel Member EDWARD LAZEAR Panel Member TIMOTHY J. MURIS Panel Member JAMES MICHAEL POTERBA Panel Member CHARLES O. ROSSOTTI Panel Member LIZ ANN SONDERS Panel Member WITNESSES: STEPHEN J. ENTIN Institute for Research on the Economics of Taxation WILLIAM G. GALE The Brookings Institution FRED T. GOLDBERG, Jr. Skadden, Arps, Slate, Meagher & Flom LOUIS KAPLOW Harvard Law School

PANEL STAFF AND DFO:JONATHAN ACKERMAN, ROSANNE ALTSHULER, TRAVIS BURKBENJAMIN GETTO, MARK KAIZEN, JEFFREY KUPFEr


2 I-N-D-E-X SPEAKER PAGE SECRETARY SNOW 3 FRED T. GOLDBERG, JR. 26 LOUIS KAPLOW 68 WILLIAM G. GALE 80 STEPHEN J. ENTIN 94


3

P-R-O-C-E-E-D-I-N-G-S 1

(10:02 a.m.) 2

CHAIRMAN MACK: Good morning, everyone. 3

First of all, I want to welcome everyone to the first 4

meeting of the President's Tax Panel. I'm very 5

pleased this morning that Secretary Snow could join 6

us. 7

We're going to ask the Secretary to make 8

his comments first. And because of his schedule, we 9

want to give him that opportunity. And then we 10

understand that he will have to leave us. 11

And then I will have an opening statement 12

that will kind of run through mostly some 13

organizational things, tell you a little bit about how 14

we are going to proceed. And then other members of 15

the panel will have some comments to make as well. 16

And then we will get started. 17

With that, Mr. Secretary, again, welcome 18

and we look forward to your comments. 19

SECRETARY SNOW: Thank you, Mr. Chairman, 20

Mr. Vice Chairman, members of the panel. Thank all of 21

you for being here today and the witnesses. You put 22

together an extraordinarily talented group of 23

witnesses today to launch the panel. 24

I think you know that this is a matter of 25


4

extraordinary importance to the President and to the 1

country. The President is committed to major tax 2

reform, to real tax reform, to something more than 3

just moving the boxes around, to finding what the 4

opportunities are here to make the tax code fairer, 5

simpler, and more growth-oriented. 6

This panel has an opportunity to play an 7

extraordinary part, it seems to me, in what could well 8

be an historic effort to reform the code of the United 9

States, that code that touches every state, every 10

city, virtually every American, certainly every 11

American family. And if you can find a way to give us 12

options that will really put us on a path to 13

simplifying it, making it less complex, making it 14

fairer, making it more growth-oriented, you would have 15

done something of extraordinary importance, I think, 16

as public citizens to advance the interests of our 17

nation. 18

We have the most successful economy in the 19

world, the most dynamic economy in the world. I think 20

we continue to create the most opportunities for our 21

citizens of any country in the world. And, yet, we 22

have a tax code that in many ways doesn't help that, 23

that gets in the way of that, and that is a source of 24

enormous angst and anxiety and concern to the average 25


5

American family, sort of mind-boggling when you think 1

of the path we're on with the code. Today, to say 2

it's murky, I think, would be an understatement. 3

Albert Einstein once observed that the 4

code was the only thing he had ever discovered in his 5

whole life that was totally impenetrable to the mind 6

of man. And that was a long time ago and has become 7

a lot murkier over the course of the last 50 years 8

since he said that. More than a million words, the 9

regulations have more than doubled in terms of page 10

length over the past 20 years. 11

Today's short form -- and this sort of 12

puts it in perspective. Today's so-called short form, 13

the short income tax form, as some of you fill out, 14

takes more than 11 hours to prepare. That's about the 15

same as the long form took just ten years ago. 16

It's pretty clear we're on the wrong path. 17

This commission has a chance to lay out options that 18

will get us back on the right path. I know it's not 19

easy. There are a few things more complex than trying 20

to figure out how to improve tax policy. 21

But I don't know any time in American 22

history where a more talented, distinguished, or 23

dedicated group of people from the private sector with 24

prior experience and many cases in the public sector 25


6

have been brought together to focus on a major public 1

policy issue. And I don't know any time where there 2

is a combination of a President so dedicated to use 3

the results of a talented, distinguished private 4

citizen group to advance the public policy objective 5

of a code that is fairer, simpler, and more 6

growth-oriented. 7

It seems to me we owe it to America to 8

give this the best effort we can. And I know you will 9

do that. The President will give it the best effort 10

he can. I'm going to give it the best effort I can. 11

This is really in the forefront today of the public, 12

the domestic public, policy agenda of the President of 13

the United States. 14

When you think about the code, it would be 15

nice if somebody could say that it looked like it was 16

put together for a reason, rather than being the 17

accretions of a long series of individual ad hoc 18

actions and accommodations. And, yet, if you looked 19

at it, it really looks more like the latter than the 20

former. 21

I really think this is an historic 22

opportunity. I commend you. I really commend you 23

from the bottom of my heart for taking on this tough 24

assignment. And I pledge that we at Treasury will be 25


7

at your service, be available with the Office of Tax 1

Analysis, Office of Economic Analysis, and the 2

resources of the IRS as well that you can draw on to 3

help you in your deliberations. 4

And so, with that, Mr. Chairman, I thank 5

you. I wish you well with today's proceedings and 6

with the proceedings as you take the panel and the 7

hearings out across America. 8

Thank you very much. 9

CHAIRMAN MACK: Mr. Secretary, thank you 10

very much for your comments, for the challenge that 11

you have given us. We take it very seriously. And we 12

hope that we will come back with something that will 13

be of great value to you and to the President and to 14

our country. 15

And we also appreciate your offer of 16

technical assistance. I'm sure we will be drawing on 17

that. 18

SECRETARY SNOW: Thank you very much 19

CHAIRMAN MACK: Thank you very much. 20

As I said, I'm going to make an opening 21

statement that will cover a lot of the direction in 22

which the panel will be heading. Today's meeting 23

marks the beginning of the panel's important work to 24

explore ways to reform the federal tax code. 25


8

I believe that it is a good sign that we 1

are holding our first meeting to discuss reform in the 2

building that bears the name of Ronald Reagan, who 3

initiated the last bipartisan effort to reform the tax 4

code 20 years ago. 5

As we will hear today, a lot has changed 6

since then. This panel will take a fresh look at the 7

existing tax code and will formulate options for 8

making the tax system simple, fair, and productive. 9

I am privileged to serve as the panel's 10

chairman and would like to thank Vice Chairman Breaux 11

and the rest of the panel for agreeing to help tackle 12

this challenging task. 13

We have an ambitious agenda today. First, 14

I will provide some background about what the panel 15

hopes to accomplish and how we intend to accomplish 16

it. In addition, we will be hearing brief comments 17

from the other members of the panel as well. 18

I am very honored that the Treasury 19

Secretary was here to begin this important work. In 20

addition to the Secretary, we will hear from four 21

distinguished witnesses. Our first witness will help 22

us put our current tax system in context, provide us 23

a better understanding of how we got to where we are 24

today. 25


9

Our second witness will provide needed 1

background about tax system design and valuable 2

insights into how to think about choosing a base for 3

taxation. He will explain the differences between a 4

tax on income and a tax on consumption. 5

Finally, our last two witnesses will 6

describe how the choice of an income tax base or a 7

consumption tax base impacts the overall function of 8

the tax system and the advantages and disadvantages of 9

each in terms of simplicity, fairness, and economic 10

growth. 11

The President has stated clearly that tax 12

reform is a key priority and formed this panel to 13

advise the Secretary of the Treasury on options to 14

reform the tax code. 15

We have been directed to provide the 16

Secretary our findings by July 31st. To accomplish 17

this task, we intend to do our work in two stages. 18

First, we will take a comprehensive look at the 19

existing tax system. 20

Our objective is to make sure that we have 21

a full understanding of the current problems in the 22

present tax code, specifically its complexity, its 23

impact on economic growth, and its perceived 24

unfairness. 25


10

After we define the problems that need to 1

be addressed, we will turn to a consideration of 2

options for reform. These options may include making 3

modifications to improve current law, overhauling the 4

existing system, or replacing the current structure 5

and starting over. As part of our effort, we will 6

study the major reform proposals that have been 7

offered in the past as well as any new ideas. 8

As we move forward, we intend to hold a 9

number of public hearings like this one. We will 10

announce the dates and locations of those hearings 11

soon. We anticipate holding those meetings in 12

Washington, D.C. and in other parts of the country. 13

It is vitally important to all of us that 14

the public know what we are doing and have a chance to 15

provide input. We have established a Web site that 16

provides information about our activities. The Web 17

site is www.taxreformpanel.gov. We will also use the 18

Web site to receive and post public comments. 19

We welcome input throughout the process. 20

At the same time, we will also be requesting comments 21

on specific topics in connection with the first stage 22

of our work; that is, defining the problems in the tax 23

code. Today we're making our first request. We ask that 24

interested parties submit comments to the panel about 25


11

headaches the taxpayers, both individuals and 1

businesses, face because of the existing system; 2

second, aspects of the tax system that you believe are 3

unfair; third, specific examples of how the tax code 4

distorts important business or personal decisions; 5

and, fourth, goals that the panel should try to 6

achieve as we evaluate the existing tax system and 7

recommend options for reform. 8

There will be additional requests for 9

comments. For example, when we move to the second 10

stage of the process and begin considering options, we 11

will make specific requests for suggestions, 12

alternatives, and proposals for improving the tax 13

system. 14

There is nearly universal agreement that 15

we must reform the code. The tax code is a complex 16

and cluttered mess that discourages economic growth. 17

Our tax laws penalize hard work, discourage savings 18

and investment, and hinder the competitiveness of 19

American business abroad. 20

Compliance with the tax code is 21

complicated and burdensome. It is also a waste of 22

resources. Nobody likes paying taxes. But, instead 23

of making it as easy as possible, the tax code is an 24

obstacle for those who pay their fair share. 25


12

It is estimated that individuals and 1

businesses spend at least six billion hours each year 2

just to file their taxes. More than half of Americans 3

use a paid preparer to file their taxes. In fact, 4

costs incurred by individuals in connection with their 5

taxes exceed $100 billion. These numbers are 6

staggering. Americans should not have to hire an 7

expert to help them calculate their taxes. 8

The problems of complexity are not limited 9

to individual taxpayers. In fact, the compliance 10

burden on business, both large and small, is enormous 11

and adds another 20 to 25 billion dollars to the total 12

cost of compliance. 13

I'm going to mention just one particular 14

area of the tax code. And that is the AMT. The AMT 15

imposes a second tax system that is separate but 16

parallel to the regular income tax system and requires 17

that taxpayers compute their taxes twice. 18

The AMT was enacted in 1960 to target a 19

small group of high-income taxpayers who were avoiding 20

paying all income taxes. Since then, changes to the 21

AMT and inflation have caused it to apply to large 22

numbers of middle-class taxpayers by denying families 23

benefits that are available under the regular tax 24

system. 25


13

The number of Americans who will be 1

confronted by the AMT will grow from 3.8 million, 2

where it is today, to 51 million taxpayers just 10 3

years from now. 4

And, in conclusion, Americans are 5

demanding a better tax system. It should be simple, 6

transparent, and easy to understand. It should be 7

stable and predictable in order to permit informed 8

planning and decision-making. It should encourage 9

economic growth. And it should minimize the cost of 10

compliance and intrusion into the lives of taxpayers. 11

We look forward to completing this 12

important task and to presenting options that will 13

ensure a better tax system for ourselves and for 14

future generations. 15

And, with that, I will turn to the Vice 16

Chair for any comments you have. 17

VICE CHAIRMAN BREAUX: Thank you very 18

much, Mr. Chairman. 19

I would open by saying that I cannot think 20

of a finer colleague to serve with as the chairman of 21

this committee and participate and look forward to 22

working with than the former senator from Florida, 23

Connie Mack. 24

I think it is important that the committee 25


14

have a working relationship that is able to work in a 1

bipartisan, nonpartisan fashion. This is the task of 2

this committee. And I look forward to working with 3

you in a cooperative fashion to meet the challenge 4

that this committee is facing. 5

We have an extraordinarily difficult task. 6

That is to make recommendations to the administration 7

to simplify and reform a very complicated tax system, 8

as you have outlined, and to do it in an appropriately 9

progressive way. 10

We have at the same time the challenge of 11

recognizing the importance of the home mortgage 12

deduction and charitable contributions. We also are 13

charged with making it revenue-neutral and also 14

assuming that the tax cuts of '01, '03, and '04 are to 15

be made permanent. 16

So it is an extraordinarily difficult task 17

that this panel faces, but we have an extraordinarily 18

talented group of individuals where who are on this 19

panel, both from the academic world, from the 20

professional world, people who have taught tax policy, 21

people who have run the Internal Revenue Service, and 22

people who have also served in the Congress. So while 23

the task is difficult, I think that the talent that 24

this panel brings to the table indeed is 25


15

extraordinarily outstanding. 1

We have to do it in a fairly quick 2

fashion. Previous commissions that I have served on 3

as well as other members of this panel have had a year 4

or two years to tackle difficult tasks. We have to finish5

our report by the end of July. So this is on fast track. 6

I think that is good because it will help 7

us make recommendations in a timely fashion so that 8

the administration and the Congress will have the 9

opportunity to take the recommendations. And then 10

they will be able to look at the political 11

possibilities and the political realities. 12

Our task, fortunately, now I would say to 13

the former senator and myself in that category we can 14

do this without the political concerns that will 15

dictate future decisions. We can make the best 16

possible recommendations as far as reforming this 17

system. And I am very optimistic we can do that. 18

Just one other point. I was visiting the 19

head of a law firm yesterday at a major tax firm. 20

And this was the senior partner, who told me -- he 21

says, "I don't even fill out my own tax return." 22

And here is a senior partner in a law firm 23

that specializes in tax work. So if they don't do 24

their own, how much more difficult is it for the 25


16

average citizens to comply? 1

It has been said many times that taxes are 2

the price we pay for living in a civilized society. 3

That is true, of course, but taxes should not 4

intimidate people. It should not put the fear of God 5

in people. And it should not frighten or scare them. 6

And hopefully our product will be an effort to make 7

all of that possible with good recommendations. 8

And I look forward to working with you and 9

other colleagues on the panel. 10

CHAIRMAN MACK: Thank you very much, John. 11

I will go down this side of the table and 12

then come back to this side. I am going to use this term 13

that has been used a couple of times already, 14

"former." We probably won't use too many titles in 15

this group as time goes by but former Congressman Bill 16

Frenzel. 17

MEMBER FRENZEL: Thank you very much, Mr. 18

Chairman. I think the two of you have stated the 19

problem. And you two and the Secretary have dropped 20

the challenge on us. It is an interesting assignment, 21

I think, and we will all find ourselves wholly 22

occupied by it for the next months. 23

It is an important job. And we are all I 24

think glad to be here. I am pleased and flattered to 25


17

be picked for this illustrious group. I don't think 1

any of us sought this chore, but it has come our way 2

and we'll do the very best we can with it. 3

With that, Mr. Chairman, I yield. 4

CHAIRMAN MACK: Mr. Rossotti? 5

MEMBER ROSSOTTI: Well, I welcome the 6

opportunity to participate in this panel because I 7

believe the objectives that the President and 8

Secretary Snow set out are eminently achievable, 9

notwithstanding the difficulties. 10

I spent most of my life in the business 11

world, but I did take an unexpected five-year detour 12

as IRS commissioner. In both of those capacities, I 13

certainly saw close up the costs imposed by 14

unnecessary complexity in a tax code that is ever 15

changing, never standing still. 16

Based on that experience, I firmly believe 17

we can collect the revenue the government needs in a 18

much simpler and fairer way if we just have the will 19

to do it. And so I am delighted that the President 20

has given us this task. 21

While there are many objectionable 22

features in the current tax system and the chairman 23

and vice chairman mentioned some of them, one of the 24

worst of them in my view is that honest and diligent 25


18

taxpayers, who are, fortunately, the majority in this 1

country, pay a great deal extra to make up for the 2

minority who cut corners and don't pay what they owe. 3

And I think that part of the problem also 4

is a very solvable problem. And part of the solution 5

lies in developing a more straightforward tax code 6

that is less easily manipulated. 7

So I look forward to contributing to the 8

work of the panel and ultimately presenting to the 9

President realistic options to make the tax system 10

work better for the American people. 11

Thank you, Mr. Chairman. 12

CHAIRMAN MACK: Charles. 13

Liz Ann Sonders? 14

MEMBER SONDERS: Thank you, Mr. Chairman, 15

Mr. Vice Chairman. 16

It is also my pleasure to be associated 17

with this. It is a pretty big task that we are 18

charged with but I think an extremely important one. 19

There are obviously a lot of routes you 20

can take to making tax code simpler, fairer, more pro 21

growth. And I think the simplicity is the most 22

obvious one and, arguably, the most simple one. For 23

lack of a better word, it's pro growth. And I am also 24

a big fan of having been a market participant and an 25


19

observer of investors for a long time, I'm a believer 1

in the growth of this economy. 2

And I think that this has been one of the 3

issues -- our current code very much disincentivizes 4

the things that really get behind the growth in our 5

economy and will likely keep this economy, as 6

Secretary Snow said, the real engine of growth overall 7

globally. 8

The fairness issue is obviously the more 9

difficult one and I think the piece of this that is 10

going to be possibly the tougher task here. There is 11

no question that the current code, particularly in its 12

complexity, is a drag on the economy, both in terms of 13

what it does to incentives for savings and investment 14

but also just the behavioral side of this. 15

I am a student of and a keen observer of 16

the concept of behavioral finance. And I think the 17

same thing very much can be applied to the way we look 18

at the tax code and the impact it has on behavior. 19

So I also hope through this process that 20

we can make assessments of the likely benefit that 21

should accrue to overall economic growth by virtue of 22

the changes that we put forth. 23

And we are the engine of growth globally, 24

but we also have become very much a consumption 25


20

economy versus the rest of the world that is more of 1

a savings economy. Hopefully this process will help 2

to ease some of those imbalances. And I am very much 3

looking forward to the next six months. 4

Thank you. 5

CHAIRMAN MACK: Thank you, Liz Ann. 6

Mr. Tim Muris? 7

MEMBER MURIS: Thank you very much, Mr. 8

Chairman. 9

Let me be very brief and say that I 10

associate myself with everything that has been said up 11

to date. The President's charge to us is simplicity 12

itself, but the task of making a tax code, making 13

recommendations for a tax code that will be simpler, 14

fairer, and more growth-oriented is monumental. 15

This is a great group. There are many of 16

my favorite people in government in the academy. 17

There are several academics like myself and several 18

people who have had government jobs, which I have had 19

as well. 20

We all know the current system is not 21

simple. It's often not fair. And it too often 22

discourages growth. So we have a lot to do. And I'm 23

anxious to get to work. 24

Thank you. 25


21

CHAIRMAN MACK: Thank you. 1

It just so happens that we have Professor, 2

Professor, and Professor on my right. Jim, why don't 3

we go with you first. 4

MEMBER POTERBA: Thank you, Mr. Chairman. 5

As someone who has spent over 20 years 6

teaching and carrying out research on the economics of 7

taxation, it is a dream opportunity to be part of this 8

very distinguished panel and to have a chance to try 9

to put some of the lessons from the economics of 10

taxation into practice. 11

There are I think a well-documented raft 12

of behavioral effects of the tax system on the 13

decisions made by firms and by households. And I hope 14

that our panel as we think about changes to the tax 15

code will try to recognize both those intended and 16

those unintended consequences the tax system may have 17

and think about the impact on a variety of different 18

decisions that taxpayers make in their economic lives. 19

The task of looking for favorable options 20

going forward I think offers us different routes. 21

This panel is in the very unusual position relative to 22

other tax policy-makers of being able to look at the 23

entire tax code and not just at specific provisions 24

and to think about wholesale reform as well as 25


22

incremental changes relative to our starting position. 1

I am confident that we can find 2

opportunities both by thinking about alternatives to 3

the current system and by thinking about modifications 4

within the structure of the current system, which 5

would lead us to be able to have a more efficient way 6

of raising revenue while also preserving revenue 7

neutrality and a fair tax code. 8

So I am very excited and looking forward 9

to the task ahead and appreciate all of your support. 10

Thank you. 11

CHAIRMAN MACK: Professor Garrett? 12

MEMBER GARRETT: Thank you, Mr. Chairman. 13

In his State of the Union address, 14

President Bush set out three objectives: pro growth, 15

easy to understand, and fair to all. I think that as 16

we go forward with those objectives, we need to keep 17

a few other things in mind. 18

I think, first, as others have emphasized, 19

we need to think about incentives. We have long used 20

the tax code to encourage people and businesses to 21

create value for our economy. And I am sure that any 22

reform proposal we bring forward will include some of 23

those. The executive order already instructed us to 24

take account of ownership and charitable deductions. 25


23

But I think we have to keep in mind the 1

tax expenditures are justified only when they change 2

behavior in the way we intend it to change. It's not 3

worth the revenue loss if a tax expenditure subsidizes 4

behavior that would occur without the tax incentive. 5

All that happens is a windfall to some at the cost of 6

all taxpayers. 7

I think, secondly, we need to keep in mind 8

fiscal discipline as we go about our work. We need to 9

keep at the forefront of our minds that a tax code is 10

primarily designed to raise the revenue for what the 11

country wants to do at home and abroad. 12

Our proposal is supposed to be 13

revenue-neutral, which I understand to require a 14

proposal to raise the same amount of money as the 15

current tax system raises. 16

Some tax reform proposals we are likely to 17

consider may not result in immediate revenue loss but 18

will substantially reduce revenue that the federal 19

government collects in the long run. 20

I think we have to focus not only on the 21

next 5 or 10 years, but we have to focus on the long 22

run and the revenue implications of what we do over 23

the course of the next 10, 15, 20 years. 24

As a country, we face an enormous deficit 25


24

of $500 billion entitlement programs that are in 1

trouble. And I think as we go about our job, we have 2

to keep that in mind as we look at provisions. 3

And then, finally, I think we have to 4

remember that progressive rates are not the only 5

important feature of a tax system that is designed to 6

be fair to all. 7

We need to consider fairness across 8

differences in tax status, looking at whether some tax 9

credits should be refundable so that those without tax 10

liability can receive incentives. We need to think 11

about how to fairly balance taxes on income from 12

wages, which are already burdened by a payroll tax, 13

with taxes placed on income from savings and 14

investment. 15

I am very much looking forward to the next 16

few months of discussion and analysis and bringing 17

forward options for reform. And I would ask that my 18

comments be made a part of the record. 19

CHAIRMAN MACK: They will. 20

MEMBER GARRETT: Full comments. [attached] 21

CHAIRMAN MACK: Right. That they will be. 22

Professor Lazear? 23

MEMBER LAZEAR: Thank you, Mr. Chairman. 24

I have been a professional economist, like 25


25

Jim Poterba, for over 30 years. And most of my work 1

has centered on incentives and productivity. There 2

are many explicit and some less apparent incentives 3

that are incorporated in any tax system. And I think 4

that we need to be cognizant of any incentives that, 5

both positive and negative, are implicit in any tax 6

program. 7

Like the chairman, I believe that we must 8

first identify the problem that we are trying to solve 9

and then select the strategy that best accomplishes 10

this goal. Specifically, I believe that we want a 11

system that encourages growth through the formation of 12

both physical and human capital, that is fair, 13

transparent, and that has staying power. There is 14

little value in recommending changes that will soon be 15

undone by the political process. 16

It is both an honor and responsibility to 17

be a member of this panel, which ultimately may guide 18

the parameters of tax reform. I look forward to 19

serving in this role. 20

CHAIRMAN MACK: Thank you, Ed. 21

And thank you for indulging us in our 22

opening comments. This may come as a surprise to you, 23

but this is really the first time that we as a group 24

have been together. And it's really the first time 25


26

for many of us who have had the opportunity to hear 1

the points of view expressed by each of the panel 2

members this morning. So again I thank each of you 3

for your comments. 4

Our first panelist, if he will come 5

forward, is Mr. Fred T. Goldberg, Jr., partner of 6

Skadden Arps, former Commissioner and Chief Counsel, 7

Internal Revenue Service. 8

Fred, we look forward to your presentation 9

this morning. 10

MR. GOLDBERG: Mr. Chairman, it's a 11

pleasure to be here today. I want to thank you and 12

your colleagues for the opportunity. I spent last 13

week working with your staff. And I would just like 14

to note that, in addition to the quality that you all 15

bring to this effort, Jeff and Jon and Rosanne and 16

the others, are terrific and I think will add enormous 17

value to where you are trying to go. 18

They displayed that value first in giving 19

me my assignment. They wanted me to talk about the 20

history of the Internal Revenue Code, taking stock in 21

where we are, and explain why we are where we are. I 22

asked for three weeks. They gave me 20 minutes. So 23

if you read quickly and I talk quickly, we will meet 24

your time limit. 25


27

I also want to apologize in advance for 1

the technology. Undoubtedly, my 14-year-old daughter 2

could make all of this work, but I am quite 3

intimidated by all of this. And at some point, I may 4

give up with the machines. 5

Where I would like to start is at the 6

beginning of 1913. The Sixteenth Amendment permitted 7

the Congress of the United States to enact an income 8

tax. In the beginning, it was tiny. 9

And we looked for analogies. And some of 10

your colleagues on the staff suggested that we might 11

think about a house. As you will see in the upper 12

right corner, indeed it was a tiny and tidy house. 13

The income tax at the beginning affected 14

less than one percent of the population. The maximum 15

rate was seven percent. And the reason that the 16

income tax affected so few people was an exclusion 17

amount or standard deduction amount. And that is how 18

people were kept off the tax rolls. If you made less 19

than 3,000 or 4,000 dollars, you didn't have to play. 20

The death tax was added three years later. 21

And, again, you were talking about one percent on 22

estates above $50,000 with a maximum rate of 10 23

percent on estates above $5 million, which in today's 24

terms is about $87 million. Again, in the beginning, 25


28

essentially it was a tax focusing on issues of 1

dynastic wealth. 2

The first time the income tax had to stand 3

up and do something different was in World War I. In 4

World War I, there was a significant increase in 5

rates, from 15 percent up to 77 percent, which dropped 6

back down to 25 percent by 1925. The important lesson 7

there is that the income tax system was being used to 8

raise revenue, to pay, as Beth Garrett said, for what we9

want the government to do. 10

There was also a sea change with the 11

commencement of World War I. International imports 12

obviously withered away. And what you will see is 13

that prior to World War I, excise taxes and tariffs 14

were about 80 percent of federal revenue. 15

Now, as some of the other panelists might 16

point out, excise taxes and tariffs are a form of 17

consumption tax. They are an ugly, inefficient form 18

of consumption tax, but that is how you can think 19

about them. That source of revenue had declined to 30 20

percent by 1924. 21

The other noteworthy fact is that by 1924, 22

we had rules. They taxed single persons differently 23

from the way we taxed married couples. We had 24

deductions for the home mortgage and other interests. 25


29

We had charitable contribution deductions. We had 1

state and local tax deductions. We had a capital 2

gains preference. And we had exemptions for children. 3

The income tax paid for war. The income 4

tax also fueled the Depression. From 1929 to 1936, 5

the Hoover administration and the Roosevelt 6

administration believed if you are in a Depression, 7

the best way out is to raise taxes. And that is what 8

they did. And, of course, the result was the 9

opposite. 10

Again, there is another point here. The 11

income tax system was viewed, incorrectly in this 12

case, but was viewed as a way to raise revenue. 13

Other highlights. In 1934, Social 14

Security. Now, I have listed on the chart here a 15

number of features of Social Security system then and 16

now to put that program in context, but the most 17

important point in the context of the income tax is 18

the last bullet: payroll tax withholding. 19

In order to fund Social Security, 20

President Roosevelt and the administration and 21

Congress enacted payroll tax withholding in 1934. 22

Well, if you were paranoid, you would think this was 23

all preplanned. But what that did is that laid the 24

foundation for probably the most important development 25


30

in the income tax, which was from class tax to mass 1

tax. 2

During that period of time, the number of 3

taxpayers increased from 5 percent to almost 75 4

percent. The way that was accomplished was, again, 5

reducing the exclusion of mass, reducing the standard 6

deduction, if you will. You brought people into the 7

rolls by saying, "More of you have to pay tax on the 8

bottom because we are going to tax more of your 9

income." And all of that structure, as you will note, 10

was built on wage withholding that had been put in 11

place eight to ten years before. 12

So that by the end of World War II, that 13

itty bitty house has gotten quite large but, on the 14

other hand, a reasonably elegant design. You can find 15

the doors, the windows, the roofs, and the chimneys. 16

You can walk right from the kitchen to the dining 17

room. 18

Before moving on, a brief accident of 19

history. And I think this is illustrative of the 20

kinds of challenges you all will face in your work. 21

The IRS had said in the '20s that 22

employer-sponsored health insurance was not subject to 23

income tax, the contributions to employer-sponsored 24

retirement programs were taxed only when distributed. 25


31

During World War II, the NLRB followed the 1

IRS lead and said, "Okay. If that's how the IRS sees 2

the world, that's how we are going to see the world 3

for wage and price control purposes." So the 4

employers could expand employer-provided health 5

insurance. Employers could expand contributions to 6

retirement programs without running afoul of 7

wage/price controls. You can see the result. 8

Between 1940 and 1950, the number of 9

workers covered by employer-provided health insurance 10

had increased from 9 percent to 50 percent. And 11

between 1940 and 1960, the number of 12

employer-sponsored pension plans, workers covered had 13

increased from 15 to 41 percent. 14

So an interaction of a view of the tax law 15

and a very practical NLRB that wanted to protect 16

workers and employers in the context of wage/price 17

controls has essentially put in place a system that 18

says we are going to do health insurance through 19

employer-sponsored plans. We are going to do 20

retirement through employer-sponsored plans. 21

And you can think that is good or bad tax 22

policy, good or bad health care policy, but what happens 23

in the tax system and what happens in the regulatory 24

context has very, very real real world effects. 25


32

Where are we after the war? The 1

government and the tax system have been transformed. 2

Federal expenditures have grown from less than 5 3

percent to a stable 17 to 22 percent. 4

I include here a point again that I 5

believe Beth alluded to. By 2040, entitlements, 6

national defense, homeland security, and interest 7

alone will consume 28 percent of GDP. That means no 8

Justice Department, Treasury Department, IRS, 9

Agriculture Department, NEA, on and on and on. 10

Federal tax revenues as a share of GDP. 11

Again, we're less than five percent of GDP before 12

World War II. Since World War II, they have been a 13

relatively stable 17 to 21 percent. By 2040, who 14

knows? 15

We have also gone from a class tax to a 16

mass tax, from less than 6 percent of us paying income 17

tax to more than 70 percent of us paying income tax. 18

The next important event is the birth of 19

the modern era. And this is the Kennedy vision. 20

President Kennedy was the first in a very significant 21

and focused way to consider the tax laws' impact on 22

economic behavior as well as its role in funding the 23

government. 24

Under President Kennedy, individual rates 25


33

were reduced from about 90 percent to 70 percent. 1

Corporate rates were reduced from 52 to 48 percent. 2

President Kennedy was the one who proposed and caused 3

to be enacted the investment tax credit. Depreciation 4

lives were reduced from about 19 years to 12 years. 5

Keogh retirement plans for the self-employed were 6

enacted. 7

This was also the first time that the tax 8

system began in a very awkward and sort of hesitant 9

way to deal with the fact that we are not alone, we 10

live in a world economy, and the result was a tax on 11

worldwide income currently. The vision is expanded. 12

We have added a gazebo to our house. 13

A mere seven years later, this was the 14

first run at tax reform. This was the first 15

legislation ever dubbed as "tax reform," as opposed to 16

a revenue act. It backed off some of President 17

Kennedy's focus on capital investment, as indicated. 18

It was the conception, if you will, in many respects 19

of the alternative minimum tax. 20

So you have President Kennedy in 1960 in 21

his first speech talking about we can use the tax code 22

to do good. We've got to get the system off the backs 23

of productive workers. We've got to use the tax 24

system to promote investment and economic growth. And 25


34

in 1969, let's start thinking about reform. 1

Moving into the '70s, there are two 2

developments I want to mention. The first has to do 3

with the virtue of work. Milton Friedman had written 4

for many years about the impact of marginal tax rates 5

on low-income workers. The interaction of welfare and 6

the tax system was in some cases creating tax rates in 7

excess of 100 percent for folks on welfare who tried 8

to get a job. 9

And President Nixon proposed a guaranteed 10

income or negative income tax that ended up as the 11

earned income tax credit. The earned income tax 12

credit is now the largest federally funded means tested 13

cash assistance program in the country. 14

There is an important point here to note. 15

Remember we went from five percent of the taxpayers. 16

The 75 percent are paying taxes. Those in the early 17

1980s, 75 to 80 percent of us had positive income tax 18

liability. That percentage has now declined to about 19

60 percent. 20

About 40 percent of all potential 21

taxpayers with positive income in any given year pay 22

no income tax. But there is a difference here. They 23

don't pay income tax because the personal exemption or 24

standard deduction has gone up. They don't pay income 25


35

tax because the earned income tax credit, the child 1

tax credit and other special provisions. 2

In order to get out of the tax system, 3

these folks have to walk in the front door, file their 4

return, pay nothing, or get a refund and walk back 5

out, as opposed to an early era, where their income 6

was less than that amount, they never bothered to 7

file. That is a big and important difference. 8

The second virtue, the virtue of thrift, 9

in 1974, we had ERISA, IRAs, 401(k) plans. Again, tax 10

policy matters. In 1975, 70 percent of active 11

retirement plan participants were in DB, or defined 12

benefit, plans. By 1998, those percentages had been 13

reversed. The house is getting larger. 14

CHAIRMAN MACK: I think I see where this 15

is going, Fred. 16

(Laughter.) 17

MR. GOLDBERG: Yes, Senator. We can just 18

skip to the end. 19

Language matters. We go from revenue acts 20

to tax reform acts to job creation acts. How we call 21

our tax bills tells us a lot. Tax expenditure, that 22

phrase is an illustration. The word is not invented 23

to do something. The word is invented to describe 24

something. 25


36

And, as you can see, there is some data at 1

the bottom. Tax expenditures it's so called, between 2

1967 and 1982 increased from 38 percent to about 74 3

percent of tax receipts. Again, that word is not 4

invented to encourage us to do something. That word 5

is invented to describe what we are doing. 6

Another point. Inflation feedstock. 7

Between '61 and '70, the annual rate of inflation was 8

2.9 percent. Between '71 and '80, that same annual 9

rate of inflation was 8.2 percent. Between 1960 and 10

1981, the average income tax rate for a median family 11

of four increases by about 50 percent. 12

When you have brackets and you fix the 13

brackets and there is inflation -- in the '70s, 14

inflation was quite high. You have a built-in source 15

for generating additional revenue. And that 16

additional revenue funds government outlays. 17

And it also lets Congress says, "We have 18

cut your taxes. Of course, we may be putting you back 19

to where you were, but we can tell you we gave you a 20

tax cut." 21

The importance of inflation in driving the 22

revenue structure of the tax system cannot be 23

overstated. In 1972, Social Security benefits were 24

indexed. The house continues to grow. Oh, there 25


37

appears to be a crack in the foundation, but we will 1

get back to that momentarily. 2

We move to the Reagan reforms. There are 3

several of these that are very important, but it is 4

useful to put it in historical context. It was 5

President Kennedy that went from 90 to 70 percent. It 6

was President Reagan that went from 70 to 50 percent. 7

It was President Kennedy that promoted the reduction 8

in depreciation periods from 19 years to 12 years. It 9

was President Reagan that promoted ACRS. 10

So you have President Kennedy staking out 11

a view. You have President Reagan staking out a view 12

that in many ways rhetorically if you look at the 13

State of the Union and everything else, rhetorically 14

builds on the Kennedy perspective. 15

In between, you have Richard Nixon, Milton 16

Friedman, a group of conservative Republicans who 17

don't focus on rate reduction, don't focus on 18

investment incentives but, again, instead come up with 19

an earned income tax credit refundable to the 20

low-income workers and indexing Social Security 21

benefits. As we look at our current political 22

environment, that may provide, if nothing else, an 23

interesting commentary on where we have come. 24

In many respects, the most important 25


38

structural impact of the Reagan reforms was indexing 1

individual tax brackets, indexing the standard 2

deduction, and indexing the personal exemption. 3

President Reagan was absolutely out of the 4

closet, totally open, and those who supported his 5

proposals said, "We are taking away the feedstock." 6

And so once you back inflation out of the tax system, 7

over the long term, that has an enormous impact on the 8

structure of your tax system and your revenue base, 9

changes that were most warranted and clearly the right 10

call, but they do have an impact. 11

It's worth footnoting President Reagan at 12

the time was responsible for the largest tax cuts in 13

our nation's history. He was also responsible for the 14

largest tax increases in 1982 and 1984. But what is 15

important about those tax increases is protecting low 16

rates was what mattered. 17

Well, if you are not going to change the 18

rates, you have got to find some other place to get 19

the money. And the place they went to get the money 20

was what I refer to as the capillaries. 21

We're not going to expand the system 22

through rate increases. We're not going to expand 23

revenue through lowering personal exemptions or the 24

standard deduction. What we are going to do is we're 25


39

going to find this little piece and go after it. 1

We're going to find that little piece and go after it. 2

We're going to find another little piece and go after 3

it. 4

The Tax Reform Act of 1986. It's sort of 5

interesting you had the Kennedy vision leading to the 6

Tax Reform Act of '69 less than ten years later. I7

1986, tax expenditures were repealed. That was the total 8

amount of tax expenditures had been repealed in the prior 9

72 years. And they reduced benefits from 72 other 10

provisions. 11

The Tax Reform Act of 1986 also brought us 12

the current individual AMT. And it was not indexed. 13

Remember, this is a period from 1981 to 1985. We're 14

indexing rates. We're indexing brackets. We're 15

indexing standard deductions. But we're not indexing 16

the AMT. 17

The individual AMT reflects the data that 18

the Chairman described. It is a horrendous event 19

looming shortly. The corporate AMT has received less 20

attention. The corporate AMT simply exacerbates 21

business cycles. It is a silly, stupid tax. The 22

effect of the corporate AMT is the corporations pay 23

more tax when they are losing money and they pay less 24

tax when they are making money. 25


40

Passive loss rules are worth noting. This 1

was the first comprehensive structural effort to deal 2

with the tax shelters that Commissioner Rossotti 3

alluded to. And it was effective. It created a 4

scheduler system that made it far more difficult for 5

individuals to shelter their income. But there is a 6

lesson there. 7

The 1986 Act is generally viewed as having 8

contributed to the sudden and significant declines in 9

real estate values. This is an important point 10

because as you look to tax reform, I believe one of 11

the most difficult challenges you will face is 12

transition. 13

The other piece of the '86 Act, phase-in 14

and phase-out provision, the so-called PEP and Pease. 15

IRA limits are worth noting because it was the 16

beginning of a trend. Now substantially all so-called 17

incentives for individuals are capped and phased out. 18

That is very important because it violates 19

notions of neutrality, especially in the context of 20

families with fluctuating incomes. If my incomes are 21

moving up and down, above and below the phase-out 22

level from year to year, I am treated very differently 23

from someone who has an average income below the 24

phase-out. 25


41

So my family income may be the same as 1

your family income over five years, but if mine goes 2

up and down and yours stays the same, I lose the 3

benefit of those incentives. The same turns out to be 4

true at the bottom. 5

The other is cost of living. You don't 6

see a lot about this, but if the phase-out for a 7

particular provision, say, is $60,000 of family 8

income, that may be fine for a small town in rural 9

Florida or rural Louisiana, but it ain't a great deal 10

in New Orleans or Miami. 11

This violates fundamental notions of 12

fairness. Once you go to phase-ins/phase-outs, that 13

is what happens. But the reason for it is not 14

irrational. It protects marginal rates, right? If 15

I'm not going to mess with marginal rates, I have got 16

to do something else. And it defends against charges 17

of unfairness. 18

It is worth noting that deductions are of 19

little or no benefit to the 40 percent of taxpayers 20

who don't owe taxes. A family of 4 with family income 21

of about $40,000 gets no benefit from a charitable 22

contribution deduction, gets no benefit from a 23

mortgage deduction, gets no benefit from a deductible 24

contribution to an IRA. And one answer is, well, they 25


42

don't pay taxes. That's the way it goes. 1

But another answer is, well, but if we are 2

trying to promote that kind of opportunity through the 3

tax code, we're doing a real poor job. And if you 4

think about a family whose income is $30,000 one year 5

and $50,000 another year, I've got $50,000 income. My 6

spouse takes time off to care for a newborn kid. I 7

drop below. The distortive effect of these provisions 8

is really quite significant. 9

Anyway, here is the house. It's a little 10

bit smaller, as you can see. The '86 Act has done 11

something but not a whole lot. 12

CHAIRMAN MACK: Were you looking for a 13

response? [laughter] 14

MR. GOLDBERG: In less than ten years, 15

promises, promises. The top marginal rates ran from 16

28 percent to 39 percent. Capital gains were once 17

again taxed at preferential rates. Tax expenditures 18

had grown from about 45 percent of receipts 19

immediately after '86 to about 65 percent by 2003. 20

Between 1987 and 2004, more than 10,000 amendments were 21

made to the Internal Revenue Code. 22

Senator Moynihan wrote a great piece about 23

how we get inured of these things. It is hard. We 24

can't describe or capture what that 10,000 figure 25


43

means. The notion that you are changing the tax 1

system 10,000 times since you did your '86 Act reform, 2

broadened the base, reduced rates, and kept it simple, 3

it just defies description. 4

Here we are between '86 and now. These 5

are the big picture policies we pursued in an income 6

tax designed to raise revenue. We want to reduce 7

rates on families and individuals. We want marriage 8

penalty relief. We want refundable child credits. We 9

want to expand the earned income tax credit, want to 10

promote savings and investment and education. So we 11

have this panoply of proposals. 12

We want to do death tax repeal. We want 13

to reduce the double tax on corporate income. We want 14

to reduce the rate on capital gains. We want to 15

provide expensing for small businesses. We want to 16

promote energy policy. We want to promote 17

international businesses. We want to close loopholes18

and combat tax shelters. 19

So ever since '86, this is what we have 20

been about. And here we are. 21

Taking stock. Chairman, you described 22

most aptly we are living in a grotesquely complicated 23

system that distorts the allocation of resources and 24

violates common sense notions of fairness. 25


44

There are two points I want to cover 1

quickly here. One is the perfect storm. The other is 2

the reasons why. Sunsets, provisions, the alternative 3

minimum tax, and deficits paint, if you will, a very 4

sad picture for us. And these are inexorable. Why? 5

What has been contributing to the difficulties we are 6

facing is entitlements. That also is inexorable. 7

So if you want to say it's sad, you can 8

blame it on the Marquis de Sade. But, in any event, 9

you all are working in a context of dealing with 10

sunsets, dealing with the AMT, dealing with deficits, 11

and dealing with entitlements. And I think it would 12

be only prudent to keep those externalities in mind. 13

A lot of it is competing virtues. It's 14

easy for all of us to criticize the complexity of the 15

tax system. But families matter. Home ownership 16

matters. Education matters. Work matters. Thrift 17

matters. Health care matters. Industrial policy 18

matters. Energy production matters. Savings matter. 19

Federalism matters. 20

And so it's easy to say we should do none 21

of this, but it's kind of hard to not do it because 22

this is not good versus bad. This is good versus 23

good. And I think it makes the task more difficult. 24

There is a distinction between promotion 25


45

and removing barriers. We talk about incentives. I 1

think there are many instances in the tax law where 2

you are not providing an incentive. You are removing 3

a barrier to constructive economic activity. 4

If you are going to use the tax code this 5

way, you can do it well and you can do it poorly. The 6

mess we have in savings incentives is inexcusable. If 7

you are going to keep savings incentives, make it 8

simple. 9

The budget rules are another reason why we 10

are here. These are terrific in the sense that they may 11

be promoting fiscal restraint. But they have surely 12

promoted bad tax policy. Sunsets, gimmicks, 13

legislating in the capillaries are the inevitable 14

outcome of the budget rules we live under and the 15

primacy we place on maintaining low rates. 16

The '86 Act is exhibit A, PEP and Pease, 17

exempting AMT from indexing, and the corporate AMT. 18

These are the reasons we are in trouble. But there is 19

another reason. It is the world around us. Global 20

competition and global capital flows have changed 21

dramatically during the past 20 years. You can see 22

the data here. 23

The income tax has failed and in my view 24

is likely unable to adapt to the world around us in 25


46

terms of global competition and capital flows, the 1

same with respect to financial derivatives. Financial 2

derivatives were nothing before 1990. Now they're $200 3

trillion. Derivatives make a hash of the traditional 4

building blocks of an income tax system. 5

Value is moving from bricks and mortar to 6

intangibles. An income tax system has difficulty 7

coping with value embedded in intangibles. You can't 8

find it. You can't value it. That makes it harder to 9

do an income tax. 10

There has been a dramatic growth in tax 11

indifferent parties, parties who are not subject to the 12

U.S. income tax. Cross-border capital flows and capital 13

accumulated by pension plans and tax-exempt 14

organizations are enormous. 15

Imagine a world where corporations issue 16

tax-deductible debt held by people who don't pay tax. 17

That's not a bad thing. It's not an evil thing. 18

It's not a tax shelter. It's not anything. It is a 19

fact of the world we live in. And here is where we 20

are. 21

Now, there are several choices here. I 22

will just offer three observations. Everybody can 23

make what they want out of the history, but I think 24

that there are several lessons to be learned here. 25


47

The first lesson is the challenge of how 1

you think about the income tax. Is it to raise 2

revenue or is it to do social policy and provide 3

industrial policy? That is the perennial struggle we 4

have had since 1960. 5

The second is that the lesson of tax 6

reform in '69 and the lesson of tax reform in '86 is 7

a cautionary note. They didn't last long, and they 8

didn't do much. 9

The third question is, there is a world 10

around us that we cannot control. And that world 11

around us, whether you are talking capital markets or 12

you are talking global trade, is and will change how 13

we have to think about how we raise revenue. 14


CHAIRMAN MACK: Thank you very much for 16

the history lesson. I think it was fascinating to 17

walk through. There were a number of items that you 18

went through, some of which you really gave emphasis 19

to, the phase-in/phase-out. 20

Identify a couple of other areas. In some 21

respects, you may have in your last comments -- the 22

purpose of the code, thinking about what we are trying 23

to accomplish, the lessons of the '69 and the '86 Acts. 24

But, again, some other areas that are similar, say, to 25


48

the phase-in/phase-out in concept that we ought to 1

focus on? 2

MR. GOLDBERG: I was instructed to recite 3

the history and express no views, but now that you 4

have given me the opportunity, I think that the issue 5

of where we are headed with entitlements is very 6

important. I mean, if we are locked into a commitment 7

to spend the kind of money, we are locked into a 8

commitment to spending, I think that in and of itself 9

should compel a rethinking of the tax system. 10

Second, I -- 11

CHAIRMAN MACK: Do me a favor now. Relate 12

that, though. I mean, I think everybody agrees that 13

the entitlements are getting bigger, but how does it 14

relate, though, to reforming the tax code? 15

MR. GOLDBERG: Again, I am now in such 16

deep water Jeff is going to shoot me when I walk off. 17

For example, Mr. Chairman, the 18

entitlements are currently a pay as you go system 19

collected through a payroll tax. Payroll tax isn't 20

the only levy. You can imagine, for example, a 21

consumption tax that would fund some portion of 22

entitlements cost. That is a more progressive tax 23

than a payroll tax. So that is an alternative that 24

one can think about in terms of a funding source. 25


49

One can imagine, for example, tax credit 1

proposals if you stay with the current income tax 2

system focused on prefunding entitlement 3

responsibilities. 4

You know, the talk now is about Social 5

Security private accounts. And you may or may not 6

like that policy, but there are other ways, additional 7

ways, in which you can create an asset base on a more 8

universal asset base. So effectively you're 9

prefunding future entitlement obligations through the 10

tax system. That's another thing that one could think 11

about. So I think they interrelate in those respects. 12

I think there is a lesson here. Things 13

grow. They get bigger. I mean, you could look at 14

Social Security. When it was enacted, 50 percent of 15

the workers and the benefits didn't kick in until 16

after you were expected to die. And now you have a 17

very different system. 18

If you look, the Earned Income Tax Credit 19

was intended to reduce the marginal rates. It's now a 20

refundable credit that goes way beyond that. 21

These may be good things. I'm not saying 22

they're good or bad. But things tend to grow. And I 23

think one of the lessons from tax reform acts is if 24

you just kind of cut the shrubbery back, it's going to 25


50

grow back to where it was. 1

You may say, "That's okay. Maybe tax 2

reform is like Thomas Jefferson. We need a revolution 3

every 12 years or 15 years. Strip the thing back. 4

Make it simple. But don't delude yourself. It's 5

going to be back in 15 years." And maybe that's the 6

best you can do and that's okay. 7

I think that the world around us suggests 8

that there are ways to do sector-based reform of the 9

income tax. If you think about sort of the whole 10

hodgepodge of savings provisions, you could dramatically11

simplify those rules on a revenue-neutral basis. If you 12

think about raising revenue from enterprise income, you 13

could radically simplify those rules on a 14

revenue-neutral basis. 15

So there are ways to work through these 16

pieces, but the only thing I really come away with is 17

I think you are better off thinking big than thinking 18

little. 19

CHAIRMAN MACK: Thank you very much. I 20

hope I didn't get you in trouble with that question. 21

MR. GOLDBERG: It was inevitable. 22

CHAIRMAN MACK: We will move down to this 23

end of the table first, Jim, if you have got a 24

question you would like to pose. 25


51

MEMBER POTERBA: Yes. You alluded to the 1

difficulties of taxing capital income and changes in 2

the global marketplace, the rise of derivatives, the 3

rise of intangibles, and global competition as being 4

factors that are really very difficult here. 5

In your judgment, is it inherently 6

impossible to address those issues within the 7

framework of an income tax? And does that push you 8

toward thinking about alternatives or is this 9

something where we have just lagged in the way we have 10

designed the regulations and implemented the code 11

given that the economy has changed underneath us? 12

MR. GOLDBERG: I think it is impossible, 13

particularly if you're trying to keep up. You know, 14

you have some little code provision that gets at some 15

little piece of something somebody figured out. And 16

then you're never going to catch up. I think in that 17

sense, it's hopeless. 18

Now, that doesn't mean that you give up on 19

an income tax, but I think it means you think very 20

differently about an income tax. And it's going to 21

differ between whether you're talking about the 22

corporate sector, where there are shortcuts that you 23

take analogous to the passive loss rules, or whether 24

you're talking about individuals whose principal 25


52

source of income is their own investments. 1

I don't think the current path is going to 2

work at all. I think it has failed. I think it is 3

going to keep failing. 4

MEMBER GARRETT: I want to continue to get 5

you in trouble if at all possible. One of the things 6

that struck me when I was looking at the budget and 7

when you sort of see where the sources of revenue are 8

coming now, as opposed to, say, 20 years ago, 30 years 9

ago, is there have been 2 big shifts. 10

One is that payroll taxes are increasingly 11

a source of revenue. If you look at '75 to 2005, in 12

1975 payroll taxes were 30.3 percent. In 2005, 13

they're 37.7 percent of all federal receipts. 14

The other shift that I think is 15

interesting is corporate income taxes. So that in 16

1945, they were 35 percent of receipts. In 1975, they 17

were 14.6. In 2005, we're only getting 11 percent of 18

our revenues from the corporate income tax, which 19

strikes me as the most complex, where a lot of the 20

dead weight loss is. 21

You focus mainly on individual taxes, 22

which is terrific, but I wondered if you could say 23

something about corporate income taxes and complexity. 24

In particular, is it worth all of our time that 25


53

businesses and the IRS spend in compliance on 1

corporate income taxes when it is such a small part of 2

our income and when we could get those taxes from 3

individuals, who, after all, are people who get the 4

money from corporations? 5

MR. GOLDBERG: Boy, Beth, you did a U-turn 6

there in the middle. Two reactions. One, while 7

payroll taxes have obviously grown substantially as a 8

source of revenue, I believe that entitlement outlays 9

have grown faster. And so I don't think you can think 10

about payroll taxes independently of thinking about 11

how much we're spending. And, again, payroll taxes 12

only fund Medicare Part A. They don't fund Medicare 13

Part B. So you've got general revenue going there. 14

But my colleague Itai Grinberg who helped 15

put this thing together talks about the government, as 16

have others. You know, we're an army with an 17

insurance company. I mean, that is what we have 18

become as a government. And I think that you have got 19

to be careful about those numbers. 20

With respect to the corporate tax, a 21

couple of points. One, we cannot, absolutely cannot, 22

hope to compete in a global economy by setting 23

corporate taxes in a vacuum. We will get killed. And 24

I think that that is the reality, and we need to come 25


54

to terms with that reality. 1

The truth is, at least in the current 2

structure, corporations don't pay taxes. Customers 3

pay taxes. Workers pay taxes. And shareholders pay 4

taxes. 5

And I think that one of the difficulties 6

we have is that the rhetoric around the corporate 7

income tax -- and it has certainly affected political 8

rhetoric -- is perhaps distracting us from the kind of 9

policy considerations that we need to make. 10

Now you need to be very careful. If you 11

say corporations don't have to pay tax at all. Well, 12

me and my buddies at Skadden Arps are going to 13

incorporate. We'll never pay tax again. So you've 14

got to watch out how you do it, but I think that that 15

is an area where the rhetorical efforts have sort of 16

gotten away from the real world policy issues. 17

You know, when you essentially control 18

world trade to the extent there was world trade in 19

1962, -- and, by the way, the appendix for this has a 20

lot of these charts in more detail -- you can pretty 21

much do what you want. But we don't. And so we can't 22

do it anymore. 23

MEMBER LAZEAR: You mentioned in your 24

comments when you were talking about the 1986 tax 25


55

reform that the basic philosophy associated with this 1

was to broaden the base but to keep the rates low. 2

And in some sense, we seem to have failed on both 3

counts because the base is not clean, nor have we 4

succeeded in keeping the rates low over time. 5

I guess the question that I would like to 6

pose to you is, do you think there is something 7

inherent in the income tax structure per se that 8

causes these oscillating rates over time? Is that 9

just a natural feature? Does the historical record 10

back that up? And if so, what would you recommend to 11

us in terms of thinking about alternatives? 12

MR. GOLDBERG: I think it is a function of 13

human nature, not the tax system. I mean, how can you 14

sit there and say it's a bad idea to encourage 15

families to save for education? You can't say that's 16

a terrible idea. So let's change the tax law. 17

Well, you know, Bill Clinton wants his own 18

credit. And Senator Coverdell wants his Coverdell 19

thing. And Senator Roth wants his thing. Part of the 20

problem is if you want the tax system to accomplish 21

these objectives, that's okay. And some would believe 22

it is an efficient mechanism for doing so. But there 23

is a right way and a wrong way. 24

You look at the list of savings 25


56

incentives. If I am a middle class family trying to 1

figure out, do I want my Hope Credit? Do I want to 2

deduct my interest on my student loans? Do I want to 3

do a 529 plan? Do I want to borrow money from my 4

Roth? What in the hell am I supposed to do? 5

Sometimes there are virtues in choices. 6

Sometimes there are virtues in no choices. There is 7

a very large virtue in my world of letting the person 8

decide. 9

Put the money away. If you want to use it 10

for education, good for you. If you want to use it to 11

buy a car to go to work, good for you. If you want to 12

save it for retirement, good for you. 13

And I think that there is a 14

micromanagement in the code right now of personal 15

behavior that is a big mistake. I think to the extent 16

you want to use the code in this particular fashion, 17

you ought to trust the people to get it right. 18

But, again, I think it is human nature, 19

sir. It's not the fault of the tax code, and it's not 20

the fault of people trying to do bad things. It's the 21

consequence of people trying to do good things. 22


much, Fred, for an excellent presentation and really 24

putting it in an historical perspective as to where we 25


57

have been and how we have gotten there. 1

The challenge of this commission is to, 2

number one, report a reform of a current structure. 3

One of the obligations we have is to make 4

recommendations based on the current income code 5

structure. 6

We also are going to have the opportunity 7

to look at other types of tax measures for collecting 8

revenues we need to run the government, including a 9

consumption tax, a VAT tax, sales tax. 10

I mean, can you just give a comment on the 11

difficulty of trying to move to a totally new 12

structure, as opposed to just doing the smaller 13

amendments to the current structure? 14

We have always sort of done little bits 15

and pieces and made incremental changes over the 16

years. One option that we could recommend is going to 17

a whole new system. 18

Can you comment just on the difficulties 19

that might be faced, I guess, either politically but 20

more probably structurally, I mean, how difficult it 21

is to go from an income tax based on wages and 22

earnings to something that would be based on 23

consumption? 24

MR. GOLDBERG: The trouble is getting deep 25


58

here, Senator. I think it's impossible. I think the 1

notion of we're going to get rid of everything we have 2

and start over is a waste of time. I don't think you 3

should bother thinking about it. 4

I think you can think about other revenue 5

sources in the form of certain types of consumption 6

taxes to permit you to do a great deal of good within 7

the context of the income taxes. 8

But once you talk about preserving 9

progressivity, which the President has said he is 10

committed to, and once you talk about preserving 11

incentives for charities and home ownership, you've 12

got income tax. 13

And I think that that is not bad because 14

I think that given -- you're just not going to throw 15

it away and start over, but I think that doesn't 16

preclude you from doing radical reform. 17

I mean, you can play a game. You can say, 18

"Well gee, if I raise $600 billion from some kind of 19

consumption tax, how much good can I do in the income 20

tax and the payroll tax?" Well, it turns out you can 21

do a hell of a lot of good for $600 billion. 22

VICE CHAIRMAN BREAUX: So the concept of 23

doing a combination income tax, VAT-type of tax from 24

a structural standpoint is more -- 25


59

MR. GOLDBERG: I think you have three 1

choices. I think one choice is to define a new 2

revenue source, like some form of consumption tax, and 3

buy all of the good things you can buy out of the 4

income tax. 5

Second, you can do base broadening and 6

say, "What am I going to do good with all of the base 7

broadening I have done?" Get rid of state and local 8

tax deductions or get rid of the rules on 9

employer-provided health care. And good luck. 10

But you can broaden your base and buy11

some good things or you can think about the tax 12

system in sort of discrete sectors. What can I do13

with respect to all of this stuff out there on 14

savings? What can I do out there with all of 15

this stuff relating to how we tax corporations? 16

What can I do about my international tax piece? 17

If you want to get into the estate and gift 18

tax, what -- and sort of think about them as19

sectors. 20

And within each one of those groupings, 21

you can do very good things and you can do very good 22

things on a relatively tax-neutral basis. But, as 23

they say, there will by definition -- the only way to 24

avoid winners and losers is to do nothing. And I 25


60

think that that is a challenge. 1

But there are three ways to approach it: 2

get some more money and do a lot of good, broaden the 3

base and do some good if you can broaden the base, or 4

think about different sectors of the tax system and 5

within each sector how can you make it work better on 6

a revenue-neutral basis. I think those are your three 7

choices. 8

CHAIRMAN MACK: Thank you very much. 9

MEMBER FRENZEL: Fred, thank you very 10

much. You have been at work in this play-pen for a 11

long time and observed the gramatis personae at work. 12

If we were to scrub the system clean, irrespective of 13

whether it's consumption or income or whatever, how 14

long would it take before a hyperactive Congress would 15

redecorate it in such a way that we would be about 16

back where we started from? 17

MR. GOLDBERG: I would give you 10 to 15 18

years. I think it's about 10 to 15 years. But, 19

again, Congressman, it depends on what you do. And I 20

think, for example -- 21

MEMBER FRENZEL: Well, we could make it 22

harder for them or easier. 23

MR. GOLDBERG: I urge you not to minimize 24

that. You could make it a lot harder depending upon 25


61

how far you're willing to go. If you do it all within 1

the current context of the income tax, it's going to 2

be 10 to 15 years at the outside if you find some 3

other ways of restructuring the income tax, you may be 4

20 years, 20-30 years, which is a long time. I mean, 5

that's a good amount of time. 6

MEMBER FRENZEL: Thanks very much. 7

MEMBER ROSSOTTI: Fred, great 8

presentation. 9

With respect to the comments you made 10

about the hopelessness of what we are currently trying 11

to do with corporate income tax, what do you think are 12

the options for solving that broadly? 13

MR. GOLDBERG: Commissioner, let me be 14

clear. I think trying to figure out how to tax 15

capital is close to impossible. I don't think it's 16

impossible to figure out a way to tax enterprise 17

income, if you will. There are those, for example, 18

who have written about book-tax conformity. 19

You pay income tax on what you tell your 20

shareholders you earn. Now, that creates lots of 21

transition issues, potentially a fair amount of 22

distortion. Obviously the accounting rules that we 23

have seen are potentially subject to manipulation, but 24

that would be radical simplification. 25


62

I tell you how much I earned. I tell 1

Uncle the same thing. 2

MEMBER ROSSOTTI: I understand. Thank 3

you. 4

MEMBER SONDERS: Fred, terrific 5

presentation, very helpful. Thank you. 6

You know, you talked a lot about personal 7

behavior, as did I in my opening comments. And I am 8

a big believer that you have to pay attention to that. 9

I think it needs to be considered as well as maybe the 10

severity word but the scoring process. 11

We know that costs are pretty effectively 12

calculated when considering any kind of reform, be it 13

major or minor or wholesale. But the economic 14

benefits or disadvantages, to some degree, are not 15

considered as well. 16

Do you think there should be some sort of 17

unique scoring process adjustment or greater level of 18

formality in thinking about the scoring process when 19

approaching a wholesale reform, as opposed to just 20

some of these Band-Aid approaches? 21

MR. GOLDBERG: You looking for -- well, 22

no. I mean, I have been through these issues about 23

dynamic scoring and about -- there's a lot of 24

confusion about revenue estimates. Revenue estimates 25


63

are dynamic today in the sense that they assume 1

changes in behavior. 2

For example, if you provide a $5,000 3

first-time home buyer credit, the Joint Committee and 4

the Treasury Department will estimate a change in 5

behavior. They're going to say more people are going 6

to buy homes. 7

So in that sense, scoring is already 8

dynamic. Scoring is not dynamic in the sense that it 9

predicts sort of aggregate impact on gross domestic 10

product, for example. 11

You can do that. My answer to your 12

question is no -- in whether you should adopt a formal 13

mechanical rule. We get to revenue-neutral by getting 14

to assume this about impact on gross domestic product. 15

I think that formality runs a fair amount 16

of risk. On the other hand, I think it's essential 17

that you take into account the impact on the economic 18

activity that tax reform properly done will stimulate. 19

I think it is an absolute deadlock 20

certainty that properly done tax reform will increase 21

economic growth. That is a certainty. I think the 22

risk in trying to go beyond that obvious proposition, 23

which is true, to saying, "Well, gee, I am going to 24

give myself credit for an extra 50 basis points on GDP 25


64

every year of growth," I think it runs some risks 1

because I'm not quite clear how sure anybody can be on 2

that number. And you move that number a little bit 3

and you move your revenue numbers enormously. 4

So it's not that you shouldn't consider 5

it. I think if you don't consider it, you're missing 6

the most obvious point. But I think if you try to 7

formalize it in "I'm going to get credit for economic 8

growth," I think you're going down a road that is 9

going to be very difficult and you are going to run a 10

credibility risk. 11

MEMBER MURIS: Thank you also for your 12

presentation. It was very helpful. 13

You present some interesting statistics 14

that just in the last 12 years, let alone over time, 15

the relatively well-to-do are paying a much, much 16

higher percentage of the income tax. And only 60 17

percent are now paying at all. Where are those 18

numbers headed? And what do you think the implication 19

is, page 60? 20

MR. GOLDBERG: Well, Page 60 shows a 21

traditional distribution table. Page 61 is some data 22

we pulled together showing the tax burden on folks 23

below the poverty level. 24

MEMBER MURIS: Right. 25


65

MR. GOLDBERG: And all this does is what 1

this tells you is it's largely a function of the 2

earned income tax credit and the refundable child 3

credit is you're taking folks below the poverty line 4

off the tax rolls and giving them money. That by 5

definition means upper income folks are paying a 6

higher percentage of whatever is being collected. 7

I think that, again, fairness and 8

distribution are exceedingly important. I think those 9

who argue that the tax system has become more 10

regressive are wrong. I think that the data suggests 11

it has become more progressive. 12

But, as one of the panelists said, that's 13

the hard one. What's fair? What's fair for people to 14

pay? But we have a tax system now where, in fact, the 15

top 5 percent of all income earners pay 53 percent of 16

the tax, and the top quarter pays 84 percent of the 17

tax. You have a situation where those below the 18

poverty level essentially have a tax burden of -23 19

percent. 20

Well, that's the world we have created. 21

That can be a good world. That can be a bad world. 22

I am a huge supporter of the earned income tax credit. 23

I think it's one of the best policies enacted in the 24

last 30 years because it does remove disincentives to 25


66

work. I think it's a terrific policy. 1

This is what we are living with. Where is 2

it going to go? The answer is if you keep expanding 3

the earned income tax credit, more and more of the tax 4

burden is going to be borne by upper income earners. 5

There is another point here I would urge 6

you all to keep in mind. All of these tables are 7

static. I think that in thinking about these tax 8

policy questions, we sort of assume they are permanent 9

wealthy people, permanent poor people. And that is 10

not true. 11

The data suggests that there is a fair 12

amount of mobility. Bill Gale is going to pick on me 13

when he comes up here, but I think that there is a lot 14

of mobility. And I think that gets back to the point 15

about fluctuations in family income. 16

I think the system now has reached the 17

point where fluctuations in family income and 18

differences in cost-of-living are kind of undercutting 19

a lot of what we are trying to accomplish in the 20

income tax. So it's not always the same bottom 20 21

percent of the same top 20 percent. 22

So don't think of these as static numbers. 23

Think of these as moving numbers. 24

CHAIRMAN MACK: Again, unless someone has 25


67

got a burning question that they have got to follow 1

up, because of time, I think we need to move on. 2

Fred, I want to thank you again for your 3

presentation. I think the material that you have 4

given us, I suspect that lots of people all over the 5

country are going to be using this background material 6

as this debate picks up. So thank you very much for 7

your input. 8

MR. GOLDBERG: I wish all of you the best 9

of luck. And just make it effective in about ten 10

years, when I retire, please. Thank you very much. 11

(Laughter.) 12

CHAIRMAN MACK: Thank you. 13

If I could ask the next panel to come on 14

forward, I would appreciate it. We are going to have 15

now again three panelists. The first panelist is 16

a professor of law and economics at Harvard Law School 17

-- Louis Kaplow. Second, from the Brookings Institute 18

and co-director of Urban Brookings Tax Policy Center is 19

William Gale, whose name we heard mentioned a couple 20

of times. And the third is Stephen Entin, who is 21

President and Executive Director, Institute for 22

Research on the Economics of Taxation. 23

And I think, Professor Kaplow, you are24

going to go first. 25


68

MR. KAPLOW: Yes, I am. 1

CHAIRMAN MACK: Okay. Great. And we are 2

going to then hear from all three of you before we get 3

into some questions. 4

MR. KAPLOW: Thank you, Mr. Chairman. It 5

is a pleasure to be here today before the President's 6

Advisory Panel on Federal Tax Reform. 7

I have been asked to step a good distance 8

back from the whirlwind tour of history that Fred just 9

presented and to address in a somewhat abstract 10

conceptual but really basic and fundamental level what 11

are the differences, the core differences, between an 12

income tax and a consumption tax system. 13

In order to do this, it is helpful to be 14

a little bit concrete and a little bit oversimplified 15

and to have a basic simple story in mind. So the 16

story I have is our taxpayer who lives in two periods. 17

In the first period, our taxpayer works, earns labor 18

income. And, of course, some of this will be 19

consumed. And the rest will be saved for retirement. 20

When our taxpayer arrives in the second 21

period, the retirement years, during the interim, 22

there will have been earnings on that savings, the 23

return, the interest, or whatever form it might take, 24

that will be received. And the taxpayer, being 25


69

retired, all that remains is to consume. So the 1

taxpayer will consume both the principal of what was 2

saved along with the return or interest on that 3

savings. 4

And I am now going to use this basic story 5

to help explain a little more concretely what are the 6

differences between an income tax and a consumption 7

tax. 8

So what is an income tax? Well, the tax 9

base is all income. But then we have to ask, what is 10

income? The standard definition that is used, often 11

called the Haig-Simons definition of income, looks at 12

income not sort of by receipts but, rather, by uses 13

and sees income in an accounting sense as consumption 14

plus changes in wealth, that those together will equal 15

income in any given year. 16

Well, given the notion of an income tax, 17

what is actually taxed in the simple story that I 18

presented? Well, in the first period, when our 19

taxpayer was working, all of the labor income would be 20

taxed, both that which was consumed and that which was 21

saved because the savings would be a positive change 22

in wealth. 23

In the second period, when our taxpayer is 24

retired, all that would remain to be taxed would be 25


70

the return on savings, which would be interest in a 1

simple example. 2

An important thing to observe at this 3

point since what I have described actually departs in 4

an important way from what we observe in practice is 5

that a pure income tax of this kind is one that taxes 6

income as it accrues. It differs from a standard 7

income tax primarily and taxes gains and losses as 8

they occur, rather than waiting for a realization 9

event. 10

In contrast, what is a consumption tax? 11

The tax base of consumption taxes all consumption. 12

And what I will be describing here is sometimes called 13

a personal or cash-flow consumption tax. A bit later 14

I will contrast it with things like a national sales 15

tax or VAT. 16

What is taxed under a consumption tax? 17

Well, this is fairly straightforward in principle. 18

The first period's tax base would be whatever the 19

taxpayer in our story consumed in the first period. 20

The second period's tax base would be consumption in 21

the second period. 22

How might you implement this form of 23

consumption tax? In the old days, it was discussed, 24

that trying to keep track of how much each person 25


71

consumes at each point in time might be rather 1

difficult as an administrative matter, but it has been 2

observed that one way one could implement a 3

consumption tax -- and it's the way that has been most 4

talked about in recent decades -- is to define the 5

consumption tax base by starting with something like 6

the current income tax base or a theoretically pure 7

income tax base and simply subtracting the change in 8

wealth. 9

This is really, again, an accounting 10

identity. If you recall our original definition that 11

income is consumption plus change in wealth, if you 12

deduct the change in wealth from both sides, you then 13

get a definition of consumption. 14

Now, that is all a bit of abstraction in 15

accounting identity. What is this in the real world? 16

Well, you could envision, for example, a pure income 17

tax that provided a 401(k) or IRA-type vehicle that 18

simply had no cap. So individuals could put all of 19

their savings in something like an IRA or 401(k). 20

What would happen? Savings would be 21

untaxed when they were earned. Any accrual, as it 22

happens, would also be untaxed. However, when it was 23

withdrawn for consumption, every bit of it would be 24

taxed, in this case for the first time. So that's the 25


72

basic operation of a personal cash-flow consumption 1

tax. 2

While I have now given you definitions and 3

the definitions differ, the question is, what do we 4

make of that difference? What are different ways to 5

think about the difference? 6

What I would like to do is present two 7

different ways of thinking about the difference, which 8

will probably seem different. But both of them are 9

entirely correct and mathematically equivalent. 10

So you could say they really are two 11

different perspectives on the same thing. I am not 12

favoring one or another but just suggesting that both 13

will help our understanding of what is involved. 14

So the first equivalence relationship I'd 15

like to describe might be called an income tax 16

perspective on the consumption tax. This view would 17

state correctly that a consumption tax is equivalent 18

to a labor income tax. Put another way, a consumption 19

tax is like an income tax that exempts capital income. 20

How can we appreciate this intuition? It 21

follows from accounting identities, but to really 22

grasp it, consider a tax that is going to be at 25 23

percent. What if it were a 25 percent consumption 24

tax? Well, individuals obviously could consume 75 25


73

percent as much as they could consume in each period 1

as in a world with no taxes. However, they chose to 2

allocate across periods. 3

What if, instead of a 25 percent 4

consumption tax, we had a 25 percent labor income tax? 5

Well, that would knock down their receipts to 75 6

percent of what they were before. And then with no 7

further tax, they would be free to allocate it as they 8

wished across periods, allowing them again to consume 9

75 percent as much as they could in a world without 10

taxes. So that is a way to see that a consumption tax 11

is indeed equivalent to a labor income tax. 12

Allow me now a second equivalence, which 13

really flips the perspective. This is a consumption 14

tax perspective on the income tax. So here the 15

statement is that an income tax is equivalent to a 16

consumption tax that applies a higher rate to later 17

consumption. The reason this equivalence is true is 18

because the income tax taxes savings on earnings that 19

were previously subject to tax. 20

Now, what is the intuition behind viewing 21

an income tax as just a consumption tax but that 22

applies differentially, heavier on future consumption 23

than present consumption? 24

Well, let's stick within period one for a 25


74

minute and imagine our taxpayer is choosing between 1

apples and oranges. The income tax, whether you spend 2

it on apples or oranges, will be taxed in the same 3

way, obviously. 4

However, if you are considering oranges 5

today in this period versus oranges tomorrow in period 6

two, the money you put aside to spend on the oranges 7

in period two, the earnings on that savings will be 8

subject to tax. 9

So if you look at the relative effect of 10

tax, it will be heavier on period two oranges than on 11

period one oranges, which is just a simple, perhaps 12

artificial way of illustrating how an income tax bears 13

differently on consumption in different periods. 14

So those are some conceptual statements 15

about the mechanics. One question that is often 16

addressed is about the distributive difference between 17

an income tax and a consumption tax. 18

There is an apparent contrast, which has 19

an obvious dimension of reality to it, which is since 20

it is a fact high-income taxpayers tend to save a 21

greater fraction of income than lower-income 22

taxpayers, they will tend to fare worse under an 23

income tax or equivalently better under a consumption 24

tax. 25


75

But one can ask whether inherently the two 1

tax bases really have different distributive 2

consequences. I would suggest as a first 3

approximation the answer to that is no. And the 4

reason is that you can play with the rate structure of 5

each. 6

So you could have a consumption tax that 7

by adjusting the rate structure ended up basically 8

having the same incidence as an income tax or starting 9

from a given consumption tax one liked, one could 10

adjust the rate structure of the income tax to have 11

the same incidence of where you started. 12

This is loosely analogous to the idea in 13

the 1986 Act that we can change an awful lot of 14

things, but if we are also allowed to adjust the rate 15

structure, we can essentially keep the distribution 16

the same. 17

What this point suggests -- and it is my 18

parting observation -- at the conceptual level is that 19

the really intrinsic difference between an income tax 20

and a consumption tax very much involves matters of 21

efficiency and administration. I'm not going to get 22

into those matters. And people disagree as to which 23

way they cut, but I think that is where much of the 24

focus appropriately should be, at least in principle. 25


76

Before I mentioned that I was describing 1

a personal or cash flow consumption tax. How does 2

that relate to other consumption tax systems? Well, 3

a VAT or a national sales tax obviously are 4

consumption taxes. They are levied directly on 5

consumption. 6

The primary difference is that without 7

a lot of administrative difficulty, one will tend to 8

apply them at a single rate. They are flat taxes of 9

a sort with no exemption. 10

Now, that, of course, has a different 11

distributive implication than the kind of consumption 12

tax I was describing before. However, I think most 13

envision that if one wanted to use a VAT or a national 14

sales tax, it would be a supplementary tax joined with 15

either a personal cash flow consumption tax so the 16

system would be all consumption tax with two 17

components or joined with an income tax. 18

And whichever one one joins it with, by 19

playing with the rate structure of the latter, one 20

could accomplish essentially any distributive 21

incidence that one thought was appropriate. 22

And it's just worth observing that most 23

other developed economies outside the U.S. use a VAT 24

with some sort of an income tax. 25


77

My final set of remarks tries to relate 1

these somewhat abstract conceptual statements with the 2

system that we have. And given that I only have 3

another couple of minutes, I am going to do it briefly 4

and hitting sort of the main points, but I think it 5

will convey much of the important reality. 6

The question here is, what really is our 7

existing income tax? Ostensibly, our income tax is a 8

tax on income. But, in fact, I think most would agree 9

that substantial departures from an ideal income tax 10

make it a hybrid, somewhere between a pure accrual 11

income tax and a pure consumption tax. 12

What are some of the major categories of 13

departure? Well, departures from an income tax in the 14

direction of a consumption tax are many: consumer 15

durables, notably housing; many forms of retirement 16

savings, but only those in qualified plans of programs 17

of one sort or another. 18

There's preferential treatment of much 19

investment income outside of retirement savings, 20

deferral through the realization requirements, step-up 21

basis at death, preferential rates, accelerated 22

depreciation. Also, an under-explored area is the 23

human capital is essentially taxed on a realization 24

basis as well. 25


78

If you add all of this together, a 1

tremendous portion of the entire capital stock is 2

taxed entirely or substantially as if we were under a 3

consumption tax, rather than under an income tax, just 4

an observation, not necessarily a criticism or a 5

compliment. 6

There are also departures from pure income 7

taxation in the opposite direction. That is, there 8

are certain respects in which the tax on the capital 9

stock is heavier under the current system than it 10

would be under an idealized income tax system. The 11

two major areas I would identify are inflationary 12

gains. 13

You are all aware that we index the rate 14

brackets and the like for inflation, but we do not 15

index the computation of interest for basis, which 16

means that much capital income, especially in high 17

inflationary periods, is taxed much more than a pure 18

income tax would tax it. 19

The other major departure is the corporate 20

income tax to the extent it's not fully integrated 21

with the individual income tax. And various proposals 22

have addressed how that might be done. 23

If you put these departures toward heavier 24

taxation of capital together with an earlier laundry 25


79

list of departures toward consumption tax treatment of 1

capital, then that is probably that we are between an 2

income tax and a consumption tax, probably closer to 3

a consumption tax than a pure income tax, but that 4

varies over time as different tax reforms have been 5

enacted. 6

My final remark is just, well, what do we 7

make of the current hybrid system? One observation 8

follows almost by definition from what I have stated. 9

If you wanted to implement something 10

vaguely like a pure income tax or consumption tax, you 11

would be making quite a substantial reform, even aside 12

from myriad tax expenditures involving health care, 13

college, whatever it might be. 14

The second observation -- and this relates 15

to many of the comments that Fred made, especially the 16

more passionate ones -- is that when we look at the 17

cost of the hybrid system, the fact that we are in the 18

middle, often it's comfortable to be in a moderate 19

middle position taking the best of both. But in many 20

ways, we have the worst of both. 21

So there is economic distortion because we 22

don't uniformly treat everything in the middle. Some 23

things are treated at one extreme, some at another 24

extreme. And the wide variations create much economic 25


80

distortion. 1

The second observation is that when you 2

think about the massive administrative compliance and 3

avoidance cost of the current system, many of them 4

actually involve gaming the system due to the fact 5

that we have all of these differences in the hybrid 6

system. So much of it involves boundary policing and 7

keeping the various unsystematic, conflicting, and ad 8

hoc compromises we have made in line. 9

So the suggestion again is if one did make 10

the major reform moving toward either type of pure 11

system, there would probably be much gain to be had, 12

both on economic distortion and on complexity, 13

simplicity, and the like. 14

Thank you. 15

CHAIRMAN MACK: Our next presenter is Mr. 16

William Gale. Bill, go ahead. 17

MR. GALE: Mr. Chairman, Mr. Vice 18

Chairman, members of the panel, I would like to thank 19

you for inviting me to testify this morning. You have 20

an exciting and challenging task in front of you. And 21

I am happy to provide whatever help I can in that 22

regard. 23

In preparing comments about tax reform and 24

tax policy, I often feel like everything has been said 25


81

and everyone has said it over the past 20 years. So 1

I wanted to start off with a little bit of a different 2

tack before I turn to my overheads. And that is I 3

want to quote from Yogi Berra and Winston Churchill, 4

two names that you don't often hear in the same 5

sentence, because I think that it provides the right 6

context for my comments. 7

Yogi Berra, the great social philosopher, 8

said that, "In theory, theory and practice are the 9

same. In practice, they're different." 10

To paraphrase Winston Churchill, my 11

comments are essentially in the real world, the income 12

tax is the worst tax except for all of the others. 13

And so the focus of my comments will be a 14

little different than Louis' in that Louis was at a 15

very high level of theory unsullied by the real world. 16

I want to get my hands dirty in the real world because 17

I think that is a first order consideration in talking 18

about tax policy. 19

So before we turn to the consumption 20

versus income tax issue, let me just note that that is 21

only one of five issues, really -- there are only four 22

issues listed here -- one of really five issues in tax 23

reform. 24

The most obvious issue is the tax base, 25


82

what are you going to tax? And here the question is 1

income and consumption, but there are also 2

alternatives. There are wages. There are hybrids. 3

There are things that we can't even summarize because 4

they are so complicated. 5

The second issue is what kind of 6

exceptions to that tax base do you want to have? 7

Deductions, exemptions, education subsidies, child 8

subsidies, health subsidies, et cetera. And that is 9

in some sense a bigger issue than the tax base. 10

This is exactly what Louis was saying 11

before. The difference between a pure consumption tax 12

and a pure income tax is not that big. But if you 13

could get all the junk out of the code and get a broad 14

consistent base, that would be a big change relative 15

to the difference between a pure income tax and pure 16

consumption tax. 17

The third issue, of course, is tax rates, 18

whether they're flat or graduated. 19

A fourth issue is where you actually get 20

the money: individuals, businesses, automatic 21

withholding, third party withholding, et cetera. 22

And a fifth issue is actually the level of 23

revenue. I didn't put this on this overhead because 24

you have already been tasked to do a revenue-neutral 25


83

reform, although I endorse all of Fred Goldberg's 1

comments in regard to the entitlement issue. 2

All right. Tax reform in theory and 3

practice. In theory, it is very easy to write down 4

much better tax systems than we have. Any of us could 5

list a half a dozen prototypes that work better. 6

They're simpler. They're more efficient, et cetera. 7

But in the real world, the changes that 8

you need to make to those idealized proposals to get 9

them through Congress, to get them past the efforts of 10

lobbyists, to get them beyond the ingenuity of the tax 11

shelter industry, to make them consistent with the 12

fickle and malleable nature of public opinion, all of 13

those changes make taxes more complicated, less 14

efficient, and less fair. 15

And if you don't believe me, I appeal to 16

every tax system in every country in the world. There 17

are no countries that have simple tax systems that 18

raise revenues on the order that we raise in this 19

country. 20

The implication of this is that comparing 21

the actual system to a system that only exists on 22

paper is fun but is not likely to be very informative 23

about what happened if you actually aimed to hit that 24

system. So we need to think about real world 25


84

comparisons between the current system and 1

alternatives. 2

Then just before I turn to comparing 3

consumption and income taxes, let me note a couple of 4

issues here. As Louis mentioned, there are many ways 5

to design consumption and income taxes. And so what 6

I will be talking about is sort of central tendencies 7

for one tax versus the other. 8

I sent this around for comments yesterday. 9

And every comment was sort of "Yes, but," "Yes, but," 10

"Yes, but." You can always find some exception, but 11

let me just acknowledge at the beginning I'm talking 12

about central tendencies. 13

So I will think of the income tax as the 14

current U.S. system, the consumption tax as either a 15

European value-added tax or the U.S. tax system with 16

expanded 401(k)'s, like Louis said, but also with no 17

interest deduction. 18

One of the huge unintended consequences in 19

the current system is we have tax-preferred asset 20

income but we give deductions for interest. And that 21

generates enormous tax sheltering activity. 22

So any proposal that wants to expand 23

tax-preferred saving has to do something to limit 24

interest deductions. Otherwise you generate an 25


85

enormous tax shelter. 1

Okay. So let me start with progressivity. 2

Louis is right. In theory, there is no reason why a 3

consumption tax has to be less progressive than an 4

income tax. But in the real world, every consumption 5

tax ever designed has hit high income people less than 6

our current income tax system did. 7

So realistically a switch from an income 8

to a consumption tax that is revenue-neutral would 9

raise burdens on low and middle income households 10

relative to the current system, reduce burdens on high 11

income households relative to the current system. 12

Now, to be clear, this does not require 13

high tax rates. The 1986 example is a shining example 14

there. If you clean out the base, you have a lot of 15

revenues that you can use to reduce tax rates. 16

The second issue on the progressive income 17

tax is that it acts as a partial insurance mechanism. 18

If your income falls by a certain percentage, your 19

taxes fall by more than that. And, therefore, your 20

after-tax income falls by less than that. 21

So the progressive tax system acts as a 22

partial insurance mechanism. That is important in a 23

world where it is virtually impossible to ensure 24

against income fluctuations. 25


86

In a consumption tax, it is possible to 1

have those things in there, but most of the 2

consumption tax proposals that are out there don't 3

have that feature. 4

All right. Another issue is which is the 5

better measure of ability to pay income or 6

consumption. Here I think there is a massive 7

difference between theory and the real world. 8

Every theoretical model will tell you that 9

consumption is the right measure of a household's 10

ability to pay. In the real world, I think that is 11

wrong. And I think that consumption can actually be 12

a really poor measure of ability to pay. Let me give 13

you some examples. 14

When people can borrow as much as they 15

want or lend as much as they want at a given interest 16

rate, then consumption is definitely a good measure of 17

ability to pay. But, in fact, people can't do that. 18

And that means that they don't have access to their 19

lifetime resources in every single year. And, 20

therefore, that raises the status of current income as 21

a better measure of ability to pay than consumption. 22

Another point that is widely known and 23

documented in the literature is that people have 24

different proclivities to save. Some save a lot. 25


87

Some save a little. 1

What is not so well-known is that that 2

fact means that differences in consumption across 3

people are not good measures of differences in their 4

ability to pay. They're not good measures of their 5

lifetime resources because you might have a high 6

lifetime income person that saves a whole lot and, 7

therefore, only consumes a certain amount. 8

You might have a low income person that 9

doesn't save at all and consumes the same amount. 10

These people have the same consumption, but they have 11

very different abilities to pay. 12

So the fact that people tend to have 13

different tendencies to save means that consumption is 14

not a good measure of ability to pay across people. 15

Finally, there are a number of situations 16

where I think it's just unambiguous that consumption 17

is a bad measure of ability to pay. I will just give 18

you two examples. 19

A family has a couple of kids. One spouse 20

stops working. Their income goes down. Their 21

consumption goes up. Under a consumption tax, their 22

taxes go up because their ability to pay appears to 23

have gone up if you use consumption as the measure. 24

Under income tax, their taxes go down because they're 25


88

measured income has gone down. 1

Another example is somebody gets sick. 2

They lose their job. They have high health expenses. 3

Again, their income goes down. Their consumption goes 4

up. I would argue in that sense that income is a much 5

better measure of their ability to pay than their 6

consumption expenditures are. 7

So I would argue in the real world that 8

income is probably a better measure of ability to pay, 9

although I recognize the theoretical issues involved. 10

All right. Let's turn to complexity. I 11

am not about to defend the level of complexity in the 12

current income tax. I do believe Fred's comment 13

earlier about human nature being that tax systems are 14

going to be complicated. European value-added taxes 15

are enormously complicated. They are not the simple 16

four-line item that you see in textbooks. 17

Many of the reasons for taxes being 18

complicated would remain under a consumption tax. 19

That includes the desire to be fair, to administer 20

social policy, to reduce evasion, and to respond to 21

political issues. 22

There is one source of complexity in the 23

current code, which wouldn't have to be in a 24

consumption tax. And that is taxing capital income. 25


89

Now, that doesn't mean it won't be in the 1

consumption tax. There were proposals in the mid-'90s 2

for something called the USA tax, which was a 3

consumption tax that floundered on how complicated it 4

was to tax capital income in that tax. 5

But that could be an area where the tax 6

system could be simpler. But, of course, it could be 7

simpler in the current tax system also. And if you 8

made all the simplifications in the current system 9

that you could, you would find that the difference of10

going from there to a pure consumption tax would not 11

be that big a deal. 12

All right. Now, there are also two areas 13

where moving to a consumption tax would be more 14

complicated than the current tax code. And that is, 15

although a consumption tax gets rid of things like 16

debt versus equity, which makes for complicated taxes 17

now, it would inevitably introduce new distinctions 18

between taxable and nontaxable flows that I can go 19

into, but the point is unless you tax literally 20

everything, you have got something that is taxable and 21

something that is nontaxable, most consumption taxes 22

choose not to tax financial income and to tax 23

nonfinancial income. But if you do that, then you 24

create a big wedge between those two types of income. 25


90

And you have people changing the nature of their 1

income from wages to capital to avoid the tax. 2

You will not have a system that can avoid 3

making distinctions that don't look like distinctions 4

in real life but do matter in the tax code. 5

The other place where a consumption tax 6

will be complicated is with all of the non-tax 7

features of society or the nonfederal income tax 8

features. 9

We have 40-some states that have state 10

income taxes. We have tax treaties with dozens of 11

countries. We have corporate accounting systems. We 12

have other income-reporting systems for stuff like 13

college financial aid and mortgage applications. We 14

have government benefit programs that depend on 15

income. 16

Anywhere where people have to hand in 17

their income tax form as evidence of their income is 18

a situation where the world is going to be more 19

complicated in a consumption tax because then they're 20

going to have to fill out their income tax form anyway 21

and turn it in. Okay? So it's not a slam dunk at all 22

that a consumption tax is going to be simpler. 23

All right. What about economic growth? 24

Well, again, in theory, there is no doubt that a 25


91

consumption tax, a well-designed consumption tax, can 1

be more productive in terms of long-term growth than 2

the current income tax. 3

The key words there are not "consumption 4

tax." They are "well-designed." A well-designed 5

consumption tax should be revenue-neutral. It should 6

broaden the base. It needs to impose a tax on old 7

capital. And it needs to shut down the differential 8

distinction between the treatment of interest income9

and interest expense. 10

If you can do that, you have the potential 11

to raise economic growth. But if you say go to the 12

flat tax and you put back in the health insurance 13

deduction and you let businesses deduct their state 14

and payroll taxes, which is what they asked for in the 15

'90s, and you put back the mortgage interest deduction 16

and you put back the charitable deduction, you will 17

not get an increase in economic growth out of that. 18

In addition, converting to a consumption 19

tax could actually blunt some of the savings 20

incentives that are in the current income tax. I'm 21

not a huge fan of all of them, I think 22

low and middle income households, they tend to work 23

fairly well. It would be a more promising way to 24

raise saving and growth by encouraging things like 25


92

automatic escalation or contributions and automatic 1

enrollment than by trying to switch to a consumption 2

tax. 3

Let me just tick off three final points 4

and I will stop. One is you will often hear people 5

say that a consumption tax taxes the underground 6

economy better than an income tax. That is not right. 7

It's based on a myth. There's this drug dealer 8

example that kind of floats around that is just wrong. 9

If you would like me to explain it, I will. 10

But the evidence is that European 11

countries, which have value-added taxes, have shadow 12

economies that are just as big as ours. So there's 13

nothing magical about a consumption tax in getting at 14

the underground economy. 15

One of the new things that came out of 16

recent consumption tax debates is dealing with 17

unstable tax systems. As you know, we have had a 18

dozen major changes in the last 25 years. It's 19

looking like we're to have more in the future. 20

One of the ways where consumption taxes 21

are decidingly inferior to income taxes is in dealing 22

with unstable tax systems. So if you are moving the 23

tax rate up and down over time, if you think of that 24

as a prototypical tax change going back and forth, 25


93

that has a much bigger effect on the return to saving 1

investment in a consumption tax than it does in an 2

income tax. 3

That is something to think about in the 4

manner of what Fred discussed earlier, that if we make 5

a change but it's not stable, then it actually matters 6

whether it is a consumption or income tax change 7

because the damage that can be done in a consumption 8

tax can actually be bigger than in an income tax. 9

Last point, another difference between a 10

consumption tax and an income tax is if you move to a 11

consumption tax, you will have transition issues. I 12

won't talk about them here. 13

Let me conclude. The income tax might 14

be a big house, it might be a messy house, it might 15

be a jumbled community, but I don't think you 16

should tear it down. I think you should try to 17

rebuild it. 18

It can be improved. Most of the changes 19

that we talk about making the system better involve 20

making the income tax simpler, more efficient, and 21

fairer. 22

If a consumption tax is added on in 23

addition to that, that is one thing. That is a way to 24

broaden the revenue base and look forward to paying 25


94

for entitlements in the next 50 years, as has been 1

discussed. But if we eliminate the income tax and go 2

to a consumption tax, we're making a huge change in 3

the biggest tax system in the history of the world. 4

We're making a change that has never been 5

tried and a change that I believe will deliver much 6

less than hoped for and is fraught with peril, both 7

large and small. 8

Thank you. 9

CHAIRMAN MACK: Bill, thank you very much 10

for those comments. 11

We now move to Stephen Entin. Steve? 12

MR. ENTIN: Mr. Chairman, members of the 13

commission, thank you very much for the opportunity to 14

be with you this morning. You have a great 15

opportunity to give us the best shot at fundamental 16

tax reform since 1986. And I certainly wish you well. 17

I will keep my comments short, perhaps submit a fuller 18

statement for the record. 19

We have heard a rather gloomy assessment 20

just now. I would like to point out that economics 21

really is not the dismal science if you have a morbid 22

sense of humor. And I would also like to counter the 23

notion that taxes are boring. 24

If you have ever been scrambling in terror 25


95

to fill out your income tax at 11:00 P.M. on April 1

15th trying to get to the post office before it 2

closes, you know that taxes can be very stimulating 3

indeed. 4

We have been charged to produce a tax 5

system with more favorable treatment of activities 6

that promote growth. We would like more simplicity. 7

Fairness is a very important consideration. I would 8

like to add visibility and transparency, which the 9

chairman brought up, as an important point. 10

Taxes tell us what government is costing 11

us. And any consumer of anything ought to know what 12

he is paying for it so that he can decide how much of 13

it he wants to buy. It's really how we hold 14

government accountable. 15

Can we improve things? I think we will 16

have an easier time achieving these objectives if we 17

choose our tax base very carefully. And I would 18

suggest to you that a consumption base or moving 19

closer to a consumption base in our hybrid system 20

would be a good thing if we are going to satisfy both 21

basic objectives for the tax system. 22

I would like to toss out some ideas about 23

what income is and what isn't. These have 24

repercussions when you consider what is fair and how 25


96

the economy works. I think we need to get them clear. 1

Income is not the ability to pay. Income 2

is the earned reward for providing labor and capital 3

to produce goods and services that other people value. 4

Income is produced. You have to work to do it. And 5

doing that means giving up leisure, and it means 6

giving up current consumption and doing saving 7

instead. It involves sacrifice. 8

Income is proportional to effort. The 9

output one produces depends on how much effort one has 10

made to acquire training, acquire capital, how long 11

one works. The goods and services we produce are 12

proportional to that effort. 13

And, therefore, I submit the fairest tax 14

is proportional to income once you have understood 15

that income is this net concept. It is revenue less 16

the cost of earning revenue. Deductions for costs are 17

necessary to measure income properly. Tax reform 18

isn't about getting rid of all deductions. 19

You don't ask the mom and pop grocery 20

store to ignore the cost of the soup that it puts on 21

the shelf and claim that the entire sale was profit. 22

And you should not expect individuals to be taxed on 23

their returns on saving without counting the saving in 24

the deferral of consumption as a cost. 25


97

If you don't save, you don't get the 1

interest and you don't get the dividends. You can't 2

put a tax on the principal and then expect the person 3

to still have the interest and the dividends. He 4

can't give you the principal and still earn the 5

interest and the dividends to pay the taxes on them. 6

You can't have your principal and eat it, too. 7

Therefore, the best real measure of income 8

is consumption. And we should be taxing what we spend 9

when we spend. 10

The neutral taxes, the ones that treat the 11

orange today and the orange tomorrow evenly, are often 12

referred to as consumption taxes, but I think you 13

should think of them as taxes on income when all the 14

costs of earning income have been correctly measured 15

in time. 16

Neutral taxes do not fall more heavily on 17

saving and investment than on consumption. They are 18

unbiased against growth activities. They are far 19

simpler than the income tax. They are fair, and they 20

are straightforward. 21

We have heard that the income tax does tax 22

people. The more that they work and produce, the more 23

that they save and earn because of the graduated 24

rates. And we have seen that the income tax hits 25


98

saving and investment harder than consumption, which 1

simply encourages consumption by penalizing saving. 2

Take a quick review of the multiple stages 3

of taxation of saving. If you earn your money and you 4

pay your tax on it, you can buy a loaf of bread and 5

make a whole week's worth of sandwiches depending on 6

how large your family is. And you can eat those 7

sandwiches, and we don't bother you again. You can 8

buy a television set and sit there looking at the 9

stream of programming, and we don't bother you again. 10

If you buy a bond, we tax the stream of 11

interest. If you have a small business, we tax the 12

stream of profit as a second layer of tax on the money 13

we put into those activities. 14

If you buy corporate stock, we are going 15

to hit the corporation first and then hit you again on 16

your dividends or if the corporation retains the 17

earnings and gets bigger and stronger and the price 18

goes up and you sell the stock, we hit you on the 19

capital gain, which is another layer of tax on the 20

retained earning. And then if you still have too much 21

left over when you are elderly, we may hit you again 22

with the transfer tax, the estate and gift tax. 23

So we have four layers of potential tax on 24

saving versus one on consumption except for those 25


99

bizarre few federal excise taxes that probably ought 1

to be canned. 2

Now, the taxes on the saving, on the 3

oranges tomorrow, are sometimes thought to be, in 4

fact, taxes on saving when they are really taxes on 5

future consumption. 6

We have heard the distinction between the 7

concept of the labor tax versus the income tax. In 8

fact, taxes don't stay where the tax writers say they 9

are putting them. 10

Taxes have economic consequences. Not 11

only is the worker or the person saving for retirement 12

so you're really taxing his earnings, which means 13

you're taxing his prior labor, but if I have someone 14

who hasn't saved yet and someone who has saved yet, 15

taxing the saver may very well hurt the current 16

worker. 17

Capital is very sensitive to tax. If you 18

put these added layers of tax on it, you get less 19

accumulated saving, less accumulation of plant and 20

equipment for the worker to work with. It depresses 21

productivity, and the wage goes down. 22

Economically most of the burden of the 23

taxes on corporations and businesses and savers 24

ultimately hit people in their role as workers because 25


100

they are less efficient and they are paid less as a 1

result. Savers can always choose to switch to 2

consumption. Consumption is nice, too. But when they 3

do, workers lose their jobs. 4

We have made many steps in the income tax 5

structure to move in the direction of a consumption 6

tax. We have pensions and IRAs. And expanding those 7

would move us even further in that direction. A tax 8

that is neutral between saving and consumption, either 9

defer tax until saving is spent or tax the savings up 10

front and not tax the returns. 11

The difference to a saver over a lifetime 12

of putting money aside for retirement in an ordinary 13

income tax structure versus a tax-deferred consumption 14

style structure is enormous. 15

I have an example here of I think 7 16

percent, 7.2 percent, interest and the 20 percent tax 17

rate, $1,000 a year from age 20 to 70. You end up 18

with $400,000 in the neutral system. You end up with 19

under $250,000 in the ordinary income taxes. It makes 20

an enormous difference. And that difference in saving 21

goes into capital formation. 22

A neutral tax would not tax corporate 23

income twice. It would be taxed at either the 24

corporate level or the shareholder level. And I agree 25


101

it really should be passed through to the shareholder. 1

This is a situation where only people pay 2

taxes, businesses don't really. Businesses are 3

legally people. In the law, they can sign contracts 4

and be sued. But that is a legal fiction. And we 5

should not be trying to tax legal fictions. 6

And then there is that added layer of tax 7

that is the death tax that ought to be eliminated. 8

That is another tax on accumulated saving that either 9

has already been taxed or if they're in a pension plan 10

will be subject to the estate tax. It's always an 11

extra layer of tax. 12

There are many types of consumption-based 13

taxes. They look different, but they really are all 14

on the same tax base, which is either income less 15

savings or income less investment. And since saving 16

equals investment, they are all on the amount of 17

income that is used for consumption. They include the 18

cash-flow tax, which is the saving-deferred tax; the 19

flat tax; the sales tax; the value-added tax; and all 20

of their permutations. 21

These things have a different point of 22

collection, but they really are on the same tax base. 23

They all treat saving neutrally versus consumption, 24

all employ expensing instead of depreciation, and 25


102

with appropriate adjustments for interest passthrough. 1

All are territorial. All have the same basic tax 2

base. 3

The objective is growth, one of the Panel's 4

objectives. And I would submit that as you do your 5

work, you ought to test and see what you are doing as 6

you proceed to the cost of capital. Is it raising the 7

tax on investment or lowering it? 8

In '86, no attention was paid. The cost 9

of capital was raised, it did not do good things for th10

rest of the decade. You had a stock market crash the 11

next year as people realized what had happened to them. 12

If you want growth, you're going to have 13

to pay attention to that as you do your work. The 14

neutral taxes will give more savings and investmen15

growth. And I think potentially it would add several 16

trillion dollars to the capital stock. 17

It would add several million additional 18

jobs, and it would be at higher wages. It would 19

probably be thousands of dollars, maybe four to six 20

thousand dollars in the middle income range, in higher 21

family income pretax simply because the added growth 22

the system would generate. And the U.S. would become 23

a jobs and investment magnet. 24

If you are going to be constrained to a 25


103

neutral, revenue-neutral, system, you really ought not 1

to ignore the growth. You will have to make sure that 2

the particular tax changes you have made actually do 3

contribute to growth. There are many tax changes that 4

will be proposed that make things look nice but don't 5

have any impact at the margin on activities that lead 6

to additional growth. And you would have to make sure 7

that as you assumed some growth or, in particular, 8

change, it was actually a change that was related to 9

growth. 10

But I think you would be very wise to do 11

that. Otherwise, you are going to be hard-pressed to 12

improve the economic climate. 13

The consumption taxes have varying degrees 14

of simplification, but they are all a good deal 15

simpler than the income tax. And the simplest tax of 16

all, of course, is simply collected at the cash 17

register. Individuals don't have to file. I don't 18

think that is a good idea. They tend to lose track of 19

how much has been taken from them over the course of 20

the year. 21

But even in the individual filing that 22

would be necessary under a cash-flow or consumed 23

income tax, you get a great deal more simplification. 24

So even if they are collected on 25


104

individual tax forms, you have no double taxation. It 1

would not be filing at the corporate level. There 2

would be no limits on savings plans. You wouldn't 3

have to choose among them. 4

It wouldn't matter whether you put your 5

money into a derivative, as Fred Goldberg said, 6

that is terribly hard to capture or an ordinary 7

savings account or a Treasury bond. As long as your 8

money was in the savings plan, it's deferred whenever 9

you took it out from whatever source you took it out, 10

it would be taxed. 11

There would be no separate calculation of 12

any taxes on capital gains. There would be no 13

depreciation scheduled for large and small businesses 14

to struggle through for each machine that they bought 15

or building that they put up. There would be no 16

foreign tax and tax credit problem to worry about, 17

although you would still have to define income at the 18

border. And there would be no phaseouts of dozens of 19

exemptions, credits, and deductions. 20

Fred mentioned that we have broadened the 21

base to preserve the rate structure. And so we have 22

gotten some revenue by phasing this and that out. But 23

when you phase out this or that, you change the effective 24

marginal rate because earning an extra dollar means 25


105

changing your taxable income by something more than an 1

extra dollar or losing part of a credit. Marginal 2

rate structures adjusted for phaseouts look like the 3

Manhattan skyline. 4

One of the worst offenders is the earned 5

income tax credit with a 21 percent phaseout, I think, 6

if you have two children. Put then on top of the 15 7

percent payroll tax and the 15 percent basic tax rate, 8

and you have someone paying almost 50 percent at the 9

margin. And so the earned income tax credit may 10

encourage people to take a low-paying job, but it 11

certainly is a deterrent to actually getting a 12

promotion. 13

Fairness gets back to the notion that 14

consumption is a fairer base of income. It reflects 15

what you have produced and worked relative to other 16

people. It respects the effort of people who work and 17

save. 18

Neutral taxes can be made progressive to 19

shelter the poor. There is no need to tax savings and 20

investment more harshly than consumption to achieve 21

progressivity. There have been a variety of ways of 22

handling progressivity already posed in various plans. 23

And the simple, clearer neutral tax would 24

be seen to be fair. Everyone would be filling out the 25


106

same, fairly simple tax form. And there would be not 1

much on there that people could duck with. And people 2

would know that their neighbors were paying their fair 3

share, too. 4

The stability and transparency, Mr. 5

Chairman, I am glad you brought that up. Only people 6

pay taxes. Businesses and things don't pay taxes. 7

Taxes are best levied on individuals. 8

The voters need to see what government 9

costs. And I think everyone who can should pay 10

something toward the cost of government. That is 11

fair. And it is important that people see that 12

government is not a free good. In particular, 13

simplicity is no excuse for dropping tens of millions 14

of people entirely from the tax rolls. 15

In conclusion, tax reform is about getting 16

the tax base right. You had better decide that before 17

you choose whether something is to be in or out of a 18

deduction because unless you know whether you're 19

trying to tax consumption or income, many things will 20

simply appear to be arbitrary. 21

For example, in a consumption-based 22

system, pensions are not a tax expenditure. They're 23

the normal treatment. The current treatment of saving 24

would be the outlier. In the income tax, the pension 25


107

is listed as a tax expenditure because you're 1

intending to tax saving and the returns immediately in 2

an income tax and putting in the bias. In the 3

unbiased system, it is the norm. It is not a tax 4

expenditure. 5

Once you have the tax base right and put 6

it in a visible form so the public knows what 7

government is doing to it, the people will tell you 8

how much government they want. And that will enable 9

you to set the rate at what they feel is appropriate. 10

Then they pick and choose how much government they 11

choose to pay for. 12

We would be raising revenue while doing 13

less damage to the economy. That is very important. 14

And if you make the tax system visible -- and some 15

consumption taxes are, and some are not -- you would 16

let the voting public realize what government is doing 17

so it can make informed decisions about how much 18

government activity to support. I think that is 19

important in a democracy. 20


CHAIRMAN MACK: Steve, thank you for your 22

presentation as well. 23

Now we'll go to some questions. I'm going 24

to start with Vice Chairman Breaux. 25


108


much, Mr. Chairman. Thanks to the three panel members 2

for their presentations. It's been a very interesting 3

dialogue to begin the discussions. 4

I would like to get some comments on the 5

question we have asked you all to give us some 6

thoughts on a consumption tax and on the current 7

income tax. Give me your thoughts on not the 8

either/or situation but perhaps on doing some type of a 9

combination recommendation, preserving the basic 10

structure of the income tax but adding to it some type 11

of a consumption tax. 12

What are the problems with that? How does 13

it work? Can you guarantee the progressivity of the 14

structure by doing an income tax with a consumption 15

tax? 16

I am not looking at it as an either/or. 17

I'm looking at it maybe as a combination. Can I get 18

some kind of comments on that thought? Louis? 19

MR. KAPLOW: Well, I will make a couple of 20

comments. I think the two main ways to move in a 21

consumption tax direction, in part, would be related 22

to things that were mentioned. One is to expand 23

ceilings on things like IRAs and 401(k)'s. 24

And, as Bill Gale pointed out correctly, 25


109

negative assets, borrowing and interest, need to be 1

included and incorporated as one moves in these 2

directions, which we have not done consistently. 3

And, as one does that, it will certainly 4

be of more benefit to those taking more advantage, 5

which will tend to be at the middle and upper income 6

levels. And by adjusting rate structures somewhat at 7

the upper end, one could have the distribution be the 8

same if one wished. 9

Likewise, adding a VAT, a national sales 10

tax, at whatever level, at 5 percent, at 15 percent, 11

somewhat reducing the income tax is another way to go. 12

And, as I alluded to, if one wanted to preserve the 13

existing distribution, one would probably need to 14

somewhat raise rates at the top, lower them at the 15

bottom, make certain transfer programs or the EITC 16

more generous. 17

Just one other word about how it works out 18

in reality. I think of those on the podium, I am on 19

the bottom of the barrel of those who might predict 20

how it would work out politically in the United States 21

if we were to do these. 22

But I think it is interesting to observe 23

that in other countries in the world, where mixed 24

systems are the norm, typically a VAT and an income 25


110

tax, many of them engage in more aggregate 1

redistribution leveling of income through the fiscal 2

system than we do. A few engage in less. And they 3

are at many different points along the spectrum. 4

So there's nothing inherent in the 5

schemes, I think, that affects distribution one way or 6

the other. But there probably are differences in 7

political systems. And how it would actually play out 8

is hard for me to say but perhaps easier for you. 9

CHAIRMAN MACK: Yes. Go ahead, Bill. 10

MR. GALE: I want to second everything 11

Louis just said but also just add that if you think about 12

the spending numbers that Fred put up earlier, unless 13

we are really serious about cutting Medicare and 14

Medicaid by enormous amounts, you know, half, 15

two-thirds over what they're projected to be, we are 16

going to need more revenue. 17

And then I say, "Well, can we get that 18

much revenue out of the existing tax system?" 19

And I think the answer is likely to be no. You can 20

broaden the base some. Maybe you can raise the rate 21

some. 22

But I understand this isn't your task 23

right now. Your task is do revenue-neutral reform. 24

But I think in doing revenue-neutral reform, you could 25


111

do the nation a huge service by setting up a tax base 1

that then could be used to finance whatever 2

entitlements we eventually would like to have. 3

The obvious way to do that is to introduce 4

a value-added tax now and use some of the revenue to 5

get rid of the AMT, some of the revenue -- I don't 6

know -- for rate reduction or whatever. But 7

eventually that value-added tax base is a very 8

powerful money machine that can be used to finance 9

entitlements. 10

I would suggest that you might want to 11

even consider earmarking the value-added tax to health 12

spending as a way of making explicit how much health 13

spending is actually costing all the American people. 14

But I think on revenue grounds, I think on 15

progressivity grounds, you're on sound basis. And I 16

think with a consumption tax in there, there is a 17

stronger case to make than income tax itself, more of 18

a straight income tax with less of the loopholes. So 19

I think on that ground, it's a positive thing to do 20

also. 21

CHAIRMAN MACK: Mr. Entin? 22

MR. ENTIN: If you had two taxes, if there 23

was a prospect of a second tax, I think people would 24

be more afraid that you were going to have a net 25


112

increase in taxes and that if it would bring on 1

substitution, that they would resist the opportunity 2

for Congress to have two taxes to raise, rather than 3

just one. I think it would be scary. 4

You could certainly have two neutral taxes 5

and split the neutral taxes in half. If you felt that 6

there was an administrative gain or a reduction in the 7

problems of evasion simply because the two rates would 8

be so low, then no one would probably be cheating on 9

either one. But a cleaner system, a more transparent 10

system would one neutral tax system. 11

We hear a lot about progressivity in 12

graduated rates. And they do contribute to 13

progressivity, but they don't necessarily contribute 14

to fairness when you realize that to earn more income 15

to get into the top brackets, you would have had to 16

produce more goods and services for others to use. 17

Remembering that income is earned by 18

giving people services and products that they wish to 19

buy from you, that you're providing a service somehow 20

to your fellow creatures, you have to realize, then, 21

that perhaps graduation is not necessarily a fair 22

thing. 23

You have to weigh the fairness of 24

punishing people the more that they work and produce 25


113

versus the kindness we would like to show to people 1

who are low-income. We would like to relieve them of 2

some of the cost of providing for defense and the 3

common good. But that is kindness, not fairness. And 4

fairness is a proportional tax. 5

The income tax is going to remain 6

distorting if you keep it. If you are talking about 7

incremental moves, you might consider that the 8

expansion of the IRAs to a more universal system, 9

shortening asset lives, moving toward expensing, 10

instead of deprecation, adjusting for interest 11

deductibility, these steps will clean up the tax 12

system without having to make a major break, such as 13

adding a whole new tax. 14

I even get 95 percent of the way toward a 15

consumption base by improving the movement away from 16

the income base toward the consumption base already 17

inherent in the system. 18

It was a mistake, for example, to let the 19

50 percent depreciation provision expire at the end of 20

last year. The last chart on my viewgraphs show that 21

it really did turn investment around and help get us 22

out of that recession. And we could see that 23

continued growth into the future. 24

So, rather than putting on a second layer 25


114

of tax, I would suggest you simply move more toward 1

the consumption base than the existing structure. 2

VICE CHAIRMAN BREAUX: Thank you. 3

MEMBER FRENZEL: Thank you, Mr. Chairman. 4

Thank you, gentlemen, for your excellent 5

presentations. 6

I would appreciate it if you would amplify 7

a little bit on the subject of transition, not in the 8

sense of paying off losers but simply the sense of 9

converting if you go from something that we are all 10

used to into something that we don't. 11

For you, Bill, I assume that would be a 12

layover with huge taxes, which Steve has warned us 13

about. But still there are some rough spots. And 14

you've got cash flow, collection. How does that all 15

fit together? 16

And for you, Steve, presumably you would 17

prefer the full consumption. How long does it take us 18

to make the switch from the current system? And what 19

are the fish hooks and costs in there that aren't 20

apparent right now? 21

MR. GALE: I will start, although let me 22

mention the transition issue going from an income tax 23

to a consumption tax is you can think of it most 24

easily as someone who saved all their life under the 25


115

income tax. 1

They paid money on their earnings. They 2

paid money on the interest, as Steve mentioned. And 3

then, boom, the minute they retire, we convert to a 4

consumption tax. And now they have to pay taxes when 5

they take the money out. 6

And they're not going to like that. And 7

they are, in fact, being double taxed. Okay? They're 8

getting the worst of both systems in that sense. So 9

the transition -- 10

MEMBER FRENZEL: So we need a separate 11

system for current assets now? 12

MR. GALE: I am sorry? 13

MEMBER FRENZEL: Do you need a separate 14

tax system for -- 15

MR. GALE: Well, the question is what to 16

do about that. Either you find some way if you want 17

to offer transition relief, you find some way of 18

exempting that tax burden, either directly or 19

indirectly. There are a number of ways to do that. 20

The issue, though, is that when we talk 21

about tax reform having positive effects on long-term 22

economic growth, the importance of actually double 23

taxing existing capital is key to that result. 24

If you give up that tax, remember, we have 25


116

trillions of dollars of capital, if you give up all 1

that tax, then you have to have a higher tax rate on 2

everything else. And that dampens the effect on 3

economic growth. 4

The studies that are out there that 5

suggest that -- I don't know -- half, two-thirds, 6

maybe more, of the growth effect goes away if you 7

allow the transition relief. So it's a trade-off 8

between equity and efficiency. 9

I do want to mention, though, the 10

transition issues are much broader than just old 11

assets. Suppose we cleaned out every tax expenditure 12

in the code. That would be like a little tax hit on 13

every little sector. 14

Transition issues would come in there. As 15

well, there are income tax provisions or tax rules or 16

things related to the income tax are written into 17

contracts in society. And if you change that, then 18

you can change the whole kind of social fabric, the 19

whole network. Everything has to be relooked at and 20

updated. 21

But it's a potentially complicated issue 22

if you're going cold turkey from an income tax all the 23

way to a pure consumption tax. If you do something 24

more narrow, then it's in the range of a manageable 25


117

issue. But it is an issue. 1

MR. KAPLOW: I will just add another word 2

or two on the pure income tax-consumption tax 3

transition. Taking the person who saves much of their 4

life, has already paid tax on that, and then under a 5

consumption tax is subject to another round of tax, I 6

guess I view it less as an equity/efficiency trade-off 7

and more as a pure efficiency question that reinforces 8

the view that one probably should be thinking about 9

giving substantial transition relief one way or 10

another. 11

And to the extent one imagined there was 12

this large growth benefit from this one-time tax on 13

capital, some estimates of benefits of consumption tax 14

do not assume that that is really obtainable. 15

Part of why I say this is if a consumption 16

tax in some significant way or some very large move 17

were going to happen, I very much doubt as a political 18

and realistic matter it would happen instantaneously. 19

There would be a report from a commission, there 20

would be movement, there would be debate, it would be 21

phased in and so forth. 22

There would be many intervening years 23

during which the prospect that any money you saved, 24

rather than consume now, you would be paying the tax 25


118

on now. And you would be paying the tax on the day 1

the VAT went from zero to 15 percent or whatever it 2

might be would have a tremendous adverse incentive 3

effect, one that we would not want to contemplate or 4

to realize. 5

So I think that the right way to think 6

about doing a significant shift in the direction of 7

consumption tax is to have substantial relief for 8

existing capital. 9

I think there are fairly straightforward 10

ways to do it. "Fairly" is a relative term. I don't 11

mean to suggest that on the back of a postcard, but I 12

think it's not monumental and insurmountable. But I 13

think that's the right mindset to be in to think that 14

substantial relief will have to be provided to avoid 15

major dislocation. 16

And given that one is doing that and doing 17

both revenue estimates and effects on growth estimates 18

and so forth, one should be realistic about that, not 19

inconsistent about it. 20

MR. ENTIN: I think the fear of having to 21

provide enormous relief is overblown. Some might be 22

necessary. But when you start withdraw saving from a 23

retirement plan, part of what you are withdrawing is 24

principal, but a great deal of it is earnings. 25


119

And those earnings are now going to be 1

taxed when you go to the store or on a personal tax 2

form as consumption, rather than as income, but it's 3

about the same amount of money. Much of what you take 4

out of your savings as you get older is, in fact, 5

taxable earnings under either system. So not the 6

whole thing is suddenly being double taxed. That is 7

absolutely not the case. 8

As you are putting money into your savings 9

through your lifetime, it is going to be taxed at a 10

lower level. There is no double tax on the build-up 11

on ordinary saving anymore. That gets a gain. 12

As you go to a consumption-based tax, at 13

least initially, on old assets, there is a great deal 14

more investment as a result of your enlightened tax 15

shift, old assets will be earning, at least 16

temporarily, a higher rate of return. You are going 17

to see the stock market rise and the gains go up. 18

So people are going to be compensated, in 19

part, by the rising stock market until at least they 20

respond by putting so much more capital in place that 21

the rates of return on capital are driven back down to 22

where they currently are on an after-tax basis. 23

So some of this is going to be handled by 24

itself by the market if you went to the pure saving 25


120

deduction, tax it when you take it out kind of tax 1

system. 2

If you go to the sort of tax system that 3

Phil English is talking about where you have the sort 4

of Roth treatment for the saving, where you put it in 5

on an after-tax basis and then don't tax the returns, 6

of course, you don't have that situation at all. But 7

I would suggest that either way it is certainly 8

workable, particularly if you consider the market 9

responses. 10

MEMBER FRENZEL: Thank you. 11

MEMBER ROSSOTTI: One question for Mr. 12

Gale. You had mentioned, just without elaborating, 13

that you thought that on the consumption tax, the VAT 14

style, you had just as many problems with collections, 15

underground economy as you do with income tax. Just 16

could you elaborate just a little bit on that? 17

MR. GALE: Sure. The classic example is 18

that of a drug dealer who under the current income tax 19

doesn't pay taxes on his drug sales -- it's always a 20

"him" by the way -- but then goes out and buys a 21

Mercedes and doesn't have to pay taxes on that. The 22

point that consumption tax advocates make is that 23

under a consumption tax, he would have to pay tax when 24

he went out and bought the Mercedes. 25


121

And that's true, but it's only half of the 1

story. If there is an income tax in place, he doesn't 2

report his income and, therefore, doesn't pay income 3

taxes. If there is a sales tax in place, he won't 4

collect taxes from the people he sells the drugs to. 5

And that wedge is the same wedge that is present in 6

the income tax system currently. 7

So if you think of an economy where there 8

is no saving, where consumption is income, right, then 9

you see it has got to be true that one tax system is 10

not better or worse than the other. 11

And so it is one of these things that 12

sounds right and then you go home and think about it 13

and say, "Well, wait a second. That can't possibly 14

be." 15

There are second order issues. For 16

example, if the drugs are purchased with money that 17

was generated illegally, then that plays into it, but 18

I think that is distinctly a second order issue. The 19

first order issue is the drug dealer avoids taxes in 20

either case. 21

MR. KAPLOW: If I could add one further 22

comment to that? Bill's point about there being two 23

sides to every transaction has got to be true and is 24

worth keeping in mind. 25


122

A significant part of the really 1

underground economy is the cash economy. Cash 2

business accounts for a significant portion of the tax 3

gap at various times that studies have been done. And 4

it's correct that if you're in a sector where there is 5

evasion, you will be losing on both ends. 6

There is a more modest administrative 7

benefit of a diversified system. This isn't so much a 8

consumption tax and an income tax. Within a consumption 9

tax, having it be half through personal cash flow, 10

kind of like the current income tax and 11

administration, and half through a VAT would have an 12

advantage. 13

A way of putting it is if you have one 14

system that taxes most, but not all, transactions at 15

30 percent and the rest at zero and you compare it to 16

a system where a lot of things that used to be zero 17

are now at 15 and a lot of other things that used to 18

be at 30 are now at 15, having a more common 19

intermediate rate, rather than some high, some low, is 20

a less distorting system in terms of economic 21

distortion. It's a bit more subtle, but I think given 22

the size of the cash economy and the cash gap, it's a 23

nontrivial issue. 24

MR. ENTIN: If you looked at what happened 25


123

in Russia after they got rid of some really bizarre, 1

very high tax, narrowly based taxes and moved toward 2

a flatter rate tax, where it simply was not worth 3

trying to evade the system, their revenues did much 4

better. There is something to that. 5

If you do split it into that kind of a 6

choice, you may have less evasion because neither rate 7

would be high enough to warrant much effort given the 8

risks of being caught. 9

You do sacrifice some transparency if 10

people do not understand that they are paying the VAT 11

if it's not there on the sales slip and if they don't 12

take the trouble to add it up over the course of the 13

year. 14

One of the South American countries has 15

gotten around that and helped people enforce the VAT 16

by saying, "Collect your VAT slips, and we will give 17

you some discount on your income tax at the end of the 18

year." So you will always demand a receipt from the 19

company. And we can somehow make them more responsive 20

and more likely to be paying the VAT. So it reduces 21

evasion of that end. 22

There is a little bit of a trade-off 23

there. Otherwise I share your comment. 24

MEMBER SONDERS: We have talked a lot 25


124

throughout the morning about the overall goal of the 1

recommendations of this panel, obviously being 2

simplicity, fairness, and pro growth. And we also 3

touched on throughout the morning a couple of the very 4

few restrictions that the President has placed on us: 5

number one, that we maintain the biases toward home 6

ownership and charitable giving, that we consider this 7

revenue-neutral, making the assumption that the tax 8

cuts from term one are made permanent. 9

But there is one other restriction. And 10

the question associated with that is I suppose to you, 11

Bill. And that is that at least one of our proposals 12

has to maintain the current federal income tax. 13

So, Bill, you specifically said that you 14

thought that there were some key improvements that 15

could be made to the current income tax structure. 16

And I was hoping you could expand on that a little 17

bit. 18

MR. GALE: Sure. Thank you. 19

Let me just mention first the revenue 20

neutrality issue is a little tricky because it's not 21

clear to me what time frame you all are supposed to 22

operate in. There are policies that are 23

revenue-neutral over five years and then fall off the 24

cliff after ten in terms of revenues. And I would 25


125

urge you to be wary of them. 1

In terms of the income tax, I don't want 2

to list 87 particular proposals. Let me give three 3

principles to follow. The first one is do no 4

harm. And when I say that, I don't mean to any 5

individual taxpayer. You're going to have to gore 6

someone's ox, no question. But do no harm to the 7

system. 8

It really is a system or is supposed to be 9

a system. That is, the way capital income is treated 10

is related to the way capital expense is treated, you 11

know, and so on. So maintaining connections between 12

various parts of the system; in particular, in capital 13

income and interest expense, I think is really 14

important. 15

The second thing is in '86, this happened. 16

And maybe it can happen again. A wholesale attack on 17

tax expenditures I think is in order. And it's not an 18

issue of repeal the provision or not. 19

Tax expenditures tend to have this 20

upside-down structure that if you absolutely looked at 21

them as spending programs, they would look ridiculous 22

because they are giving the biggest benefits to 23

high-income households, the smallest benefits to 24

low-income households because you deduct the payment 25


126

at your marginal tax rate. 1

So doing something like establishing a 2

uniform deduction rate, say 15 percent, for some of 3

these things would I think be equitable. It would 4

raise revenue that could be used to do things like get 5

rid of the AMT. And I think it would be a vast 6

improvement in the system. 7

The third thing I was going to say is 8

simplify. That's cheating because everybody wants a 9

simpler tax system, but every year the tax system gets 10

more complicated. And we have to kind of wonder what 11

is going on there. 12

What happens is that everyone makes 13

simplicity their second choice, like "I really want 14

this tax cut, and I want to make the system simpler," 15

"I really want this adjustment, and I want to make the 16

system simpler." It's sort of ever the bridesmaid, 17

never the bride. 18

And one of the things the commission can 19

do is say, "Look, it's time to take stock and get away 20

from all of these different concerns. We have an 21

over-arching concern with simplicity. And that is 22

going to dominate these 900 judgments that we make. 23

And here they are." So I think that is a real 24

contribution that the commission could make. 25


127

Again, if you simplify, you broaden the 1

base. You can use the revenues either to reduce 2

rates, to get rid of the AMT, for a lot of stuff. But 3

that puts you in a good situation in which to operate 4

because you have got revenues you can actually use for 5

some purpose. 6

MR. ENTIN: Could I add one thing to that? 7

You might consider something truly novel and take some 8

of these social engineering provisions out of the tax 9

code entirely and say that if you are going to 10

subsidize something like home ownership or health 11

insurance that it be done with a check voucher 12

subsidy somewhere elsewhere in the budget so that it 13

can compete for the federal revenues along with 14

everything else. And then you don't have to worry 15

about whether it is a tax expenditure or not. 16

Another point, though, is that this 17

business about broadening the base by getting rid of 18

tax expenditures, something is a tax expenditure in 19

one tax system, but it's normal in another. 20

Unless you have decided whether you are 21

viewing the tax base as something that looks more like 22

consumption or something that looks more like the 23

broad-based income tax definition, you will not know, 24

for example, whether a pension plan is a tax 25


128

expenditure that ought to be eliminated or normal 1

treatment that ought to be expanded. 2

So just broadening the base by taking 3

current tax expenditures measured against the income 4

tax and getting rid of them is a decision you're going 5

to the income tax base. Decide first whether you're 6

going there or you're going in the other direction. 7

The real base broadening that will occur 8

if you make the tax system more pro-growth is that the 9

economy will expand. Now, that is a kind of base 10

broadening that doesn't hurt anybody and helps 11

everyone. That's what you should be aiming at for 12

base broadening. 13

MEMBER MURIS: That is a perfect segue to 14

one I wanted to ask, which was about page 17 of Mr. 15

Entin's presentation. And I wanted to ask Mr. Gale to 16

comment on that. 17

The question is, I assume there is an 18

implied GDP growth in that. One, how big is it? Two, 19

how would it stack up? CBO for the first time put its 20

toe in the water on this sort of dynamic scoring. And 21

I'm assuming Mr. Gale will have a reaction. And I'd 22

like to hear how you respond. 23

MR. GALE: To tax reform and growth 24

generally or to dynamic scoring? 25


129

MEMBER MURIS: No, no. To what he is 1

going to say about this kind of dynamic scoring and in 2

general about how big it is. 3

MR. GALE: Sure. 4

MEMBER MURIS: I would like to have Mr. 5

Entin respond first, though. 6

MR. ENTIN: It, in part, depends on what 7

you do. If you were to strip all of the excess tax 8

layers off of capital and get the cost of capital down 9

substantially, we currently have something like a 55 10

or 60 percent tax on capital commitment. 11

It means that capital has to earn roughly 12

twice what it would otherwise have to earn to satisfy 13

the savers. With buildings, it is even worse. If 14

inflation comes back, that number gets gigantic. 15

The tax rate given the fact that we don't 16

allow you the full write-off of your plant and 17

equipment and overstate the profit means the statutory 18

rates are even higher than I have just described. 19

We are not sure just how much saving and 20

investment have been harmed and capital formation has 21

been harmed by this. But given the several trillion 22

dollars that the capital stock is today and given the 23

size of the tax rate I have described to you, you 24

would expect several trillion dollars in additional 25


130

plant and equipment structures to be built over 1

roughly a five to ten-year period. We get an 2

indication of that from previous times we have changed 3

depreciation schedules and capital gains rates and so 4

forth. 5

There is a problem in the modeling done on 6

the Hill and in the academic community in this area. 7

It's been hard to find marginal tax rate series, and 8

people have used average tax rates instead. Well, 9

they don't go in the same direction in some decades. 10

It's a very bad proxy. 11

Many of the studies in the old days that 12

got into this analysis used to assume, as we pointed 13

out or I think Fred pointed out, that we were back in 14

1962 and we were the king of the world and we had the 15

biggest, most powerful trading system. They treated 16

the United States as a closed economy. 17

The studies that use open economy models 18

and show that saving is highly elastic and investment 19

responds very quickly are showing these days a much 20

different answer than we would get from studies done 21

five and ten years ago. There are enormous benefits. 22

Now, since the capital stock is already 23

approaching eight to ten trillion, I think having 24

several trillion dollars more expected in investment 25


131

over a decade is not at all unusual in an assumption. 1

I said several million jobs. I might save 2

five. Someone else might say two. Dale Jorgenson 3

told the Kemp Commission we would get a double-digit 4

increase in GDP. I've seen other models that go 5

higher that are open and use marginal tax rates as 6

their variables. 7

And that figure I suggested is only about 8

a ten percent increase in family income. I think that 9

is well within our grasp if you do your job correctly. 10

MR. GALE: Thank you. 11

Four comments, but let me preface this 12

first with the statement that Do Not Call rules are 13

one of the best things the government has ever done. 14

Thank you. 15

MR. MURIS: Thank you. 16

MR. GALE: The first thing, I think 17

economic growth is a first order concern. It's not 18

that I don't think we should be promoting a growing 19

economy, we should be expanding. I think we should. 20

Point two, however, is I think we should 21

be cautious about statements about how tax systems can 22

dramatically raise economic growth. Let me give you 23

an example. 24

Fred's history started at World War I, 25


132

pre-World War I. I want to go back a little further, 1

to 1870 until to World War I. We had what in some ways 2

was considered a very strong period of growth in U.S. 3

economic history. We had very low taxes, no income 4

taxes to speak of, no estate taxes, no corporate 5

taxes, no pay roll taxes, just these dinky tariffs and 6

customs. Real GDP growth was 2.2 percent per person 7

during that period. 8

In the 50 years after World War II, we had 9

very high income tax rates, extremely high, extremely 10

high corporate income tax rates. We ratched up the 11

payroll tax numerous times. We had this estate tax, 12

which we all know about. Economic growth during that 13

period was exactly the same, 2.2 percent per person on 14

a real basis. 15

I don't want to argue that taxes have no 16

effect on economic growth, but I will say that if you 17

take those changes in tax policy, raising revenues by 18

15 percentage points of GDP, drastically raising 19

income tax and estate tax rates, and stick them in 20

Steve's model, it's going to say the economy doesn't 21

exist anymore. It's been taxed into nonexistence. 22

So we need to be very careful. If tax 23

changes of that magnitude don't show up in growth 24

trends, we need to be real careful about claims 25


133

about tinkering with this saving account or that 1

depreciation provision is going to create trillions of 2

dollars of growth. 3

The third point, slightly the 4

other way, nonetheless, I believe that a very 5

well-designed, well-disciplined income tax would raise 6

growth and a well-designed, well-disciplined 7

consumption tax could go a little further. 8

But most of the benefit, the studies 9

suggest, comes from getting from a current system to 10

a well-designed discipline income tax. If we can do 11

that, we have basically won the game. And then if we 12

want to talk about income or consumption tax, that's 13

fine, but that is really gravy. 14

Last point on scoring, dynamic scoring. 15

This comes up in Social Security analysis, too. These 16

proposals are going to be so big that it is going to 17

be impossible to ignore the economic growth effects, 18

nor would we want to ignore the economic growth 19

effects. 20

I think I agree with Fred that for 21

purposes of the official revenue estimates, we need a 22

score that is done on a traditional basis. Otherwise, 23

you are going to create a bias or you could create a 24

bias in favor of, an inappropriate bias in favor of, 25


134

big plans relative to small plans. 1

And the whole dynamic scoring issue is a 2

bigger issue. But basically everybody thinks their 3

proposal should be exempt from the standard scoring 4

procedures because their proposal is special. 5

Like I tell my children, yes, you are 6

unique and special, just like everyone else. And I 7

think that is the right answer here, too. 8

MR. KAPLOW: I will just offer one 9

academic side bar to some of these comments. 10

Economists often point out -- and I think we are 11

correct when we point this out -- that although growth 12

is the common coinage of good economic things in many 13

of these discussions, really, economic efficiency and 14

distortion are at the core. 15

And one very simple way of making the 16

point is you can go from a high level of distortion, 17

say, relating from present to future consumption to no 18

distortion to distortion in the other direction. And 19

there are scenarios in which that would have no effect 20

on savings, whatever. So you could have great 21

economic improvement but not necessarily more savings. 22

We also know from days of old, of 23

centrally planned economies that were wildly 24

inefficient but did have high growth rates. So it is 25


135

worth keeping in mind that probably what we care about 1

is economic efficiency, how much the tax system is 2

contributing towards subtracting from social 3

well-being. 4

It is often harder to get at and it 5

doesn't fit under the standard slogan, but there will 6

be important instances where it is quite different. 7

And the very fact that the distortion over time in 8

savings are by no means one to one I think is the most 9

important. 10

MR. ENTIN: We may be in more agreement 11

than it sounds like. But we are talking about going 12

from an inefficient system to an efficient system. In 13

that adaptation, you are going to get about a decade 14

of faster than normal growth because we go from a low 15

capital stock to a high one. 16

Thereafter, once the adjustment is 17

complete, the growth rate will go back to more or less 18

normal. But you will be starting from a higher base. 19

And that is what we all mean by this. 20

I don't think anyone is talking about 21

raising the growth rate from four percent to eight 22

percent forever. That is certainly not what anybody 23

is talking about. I would rather start from a base 24

that is 30 percent larger or 10 percent larger or even 25


136

5 percent larger and grow to a normal rate from that. 1

MEMBER POTERBA: We have talked today 2

about the compliance and income definition problems 3

that arise under the income tax. As we think about 4

possible consumption tax alternatives, thinking of a 5

retail sales tax, a value-added tax, and then 6

something like a savings-exempt income tax, can you 7

give us any guidance on where the biggest difficulties 8

would arise in trying to measure the consumption side? 9

In particular, I am thinking if we were 10

working with, say, a case where capital income versus 11

wage income was very different, but, then, anything I 12

can do perhaps with the assistance of my tax lawyers 13

to make my wage income look as though it's capital 14

income, particularly in your self-employed ventures or 15

things like that, becomes a device to change what my 16

effective tax burden would be. 17

MR. KAPLOW: I will offer one fairly broad 18

comment on that. It really goes, Jim, to exactly what 19

you were pointing out about labor versus capital. One 20

of my early slides you may remember suggested that in 21

principle a labor income tax and a consumption tax 22

amounted to the same thing. In implementation, they 23

may differ greatly and for just the reason Jim was 24

describing. 25


137

So if you are going to tax consumption at 1

the end of the day, wherever it may have come from, 2

you don't have to figure out. So to take a core 3

example, think of sole proprietors who invest capital 4

and invest their labor in a venture in which they play 5

a great role. And eventually they're spinning off 6

money that they are consuming, living on, retiring on, 7

passing on to their children and grandchildren. 8

If you had to figure out which of that 9

money came from capital and which of that money came 10

from labor, you would never emerge alive. You would 11

also have a great distortion in a system that by 12

people moving into forms of organization, such as 13

moving toward sole proprietorships, being 14

self-employed, if that was a huge tax shelter of the 15

next generation, the economic distortion, not to 16

mention the revenue loss would be great. 17

So it very much favors ex poste 18

approaches, ones that wait either as a cash-flow 19

consumption tax or a VAT, rather than a labor income 20

tax approach, which does have one virtue, that by 21

withholding at the source, it's often easier to 22

monitor evasion. 23

But I think an economy like ours, for 24

those who are compliant with withholding at the source, 25


138

we can probably also get them to send W-2's, 1099s, 1

and the like, and make sure it doesn't get lost in the 2

shuffle. 3

MR. ENTIN: I agree that the IRS has 4

always had a problem with the small business. How 5

much of the money taken out of the small business is 6

subject to the payroll tax and how much is returned to 7

capital? And, of course, they used to treat it mostly 8

as labor and, perhaps overtax the farmer and the 9

small business first. 10

With the kind of system that we're talking 11

about, whatever you put into the business is deferred. 12

Whatever you take out of the business and draw from 13

the business is taxable. And we don't care whether it 14

was from capital or labor. It's a better situation 15

for the IRS. 16

MR. GALE: You asked about the consumption 17

tax? Let me just briefly run through a couple of 18

them. The national retail sales tax, retail sales 19

taxes, have not been tried at rates of about 12 20

percent anywhere in the world and have not really 21

survived, even at that rate, because of evasion 22

issues. 23

The evasion issue here is pretty 24

straightforward. The taxes collected at a single spot 25


139

at the retail sale. And there is no third-party 1

withholding. So nobody knows that the sale took place 2

unless the government is actually standing right 3

there. 4

Contrast that to how wages are taxed5

right now. Your taxes on your wages are withheld by 6

the firm. They're sent to the government and when 7

you file your tax return, you offer a second opinion, 8

if you will, on what that wage tax is. But you file 9

your wage tax because you know that the firm already 10

sent the money in and told the IRS what your wage is 11

or presumably that is not the only reason you file 12

your wage taxes. In the retail sales tax, there are 13

real evasion issues as the rate gets above 10 or 12 14

percent. 15

The value-added tax, we have a host of 16

experience in Europe. Value-added evasion rates vary 17

from like 2 percent in England to 40 percent in Italy. 18

I don't think that tells you about the value-added tax 19

so much as the different countries. 20

So one advantage of the value-added tax 21

is that you can exempt small business and not lose 22

much money because they're exempted both on their 23

purchases and their sales. So it's sort of a net 24

wash. 25


140

The USA tax that was proposed several 1

years ago had all sorts of compliance issues that 2

Louis could probably explain better than I could. Let 3

me talk about the flat tax for a second because this 4

is sometimes considered the classic airtight system. 5

I don't think it is. 6

In the flat tax, firms pay taxes on their 7

receipts minus their outlays. Their receipts are all 8

their nonfinancial inflows, and their outlays are all 9

their nonfinancial payments. 10

So any money that is coming in to the 11

firm, the firm is going to want to call a financial 12

payment and, therefore, it not be taxed on it and any 13

money that is going out it is going to want to call a 14

nonfinancial payment and, therefore, get a deduction 15

for it. 16

Now, in firm to firm relations or 17

transactions, that is not going to be a big deal. 18

But, remember, Fred has shown us that there is a large 19

variety of what you can call tax-indifferent 20

enterprises out there: pensions, nonprofits, in this 21

case foreign firms, governments, et cetera. They will 22

be indifferent to the form of the payment. 23

So it will be possible. I don't know if 24

you can write regs to close this, but let me come back 25


141

to that. You will have massive avoidance or evasion 1

because it's not clear whether it's legal or not by 2

having all inflows characterized as finance and all 3

outflows characterized as non-finance. 4

This is a point that was raised by Charlie 5

McClure and George Zodrow, who are two consumption tax 6

advocates who have worked extensively on building 7

consumption taxes around the world. 8

If it were just something they thought of 9

on paper, I would discount it. But it's something 10

that they say is important given the operation of real 11

tax systems. So I think it is a real potential 12

concern. 13

MEMBER GARRETT: There is always part of 14

this exercise that is a bit artificial when we compare 15

income tax to consumption tax because even though we 16

say we're doing it theoretically, we all have in mind 17

the current income tax system which is terrible, 18

complex, we all dislike, everyone dislikes. And we're 19

kind of comparing it to a theoretical consumption tax 20

that seems great in theory and we don't really have 21

any practice. 22

I think some of these questions have 23

highlighted some of the possible difficulties with 24

that pure consumption tax when we bring it into the 25


142

real world. There are political difficulties, which 1

we don't have to worry about because we're not a 2

political group. 3

There is the problem of the definition of 4

the base, which Jim brings up. And then my question kind 5

of follows on to Bill's last comment, which is there 6

are also sectors that are very difficult to tax. I 7

once had something to do with drafting a subtraction 8

method consumption tax. 9

We found it very difficult to deal with 10

financial services generally, that entire sector. 11

There are questions about homes, right? What do you 12

do with the sale of homes, particularly given our 13

mandate? 14

I wondered if you could identify for us 15

other sectors, other activities that will be 16

particularly troublesome if one attempts to deal with 17

consumption, to move entirely to a consumption tax. 18

MR. KAPLOW: It partly relates to Jim's 19

question. I mean, there are some sectors. So going 20

back to an earlier discussion about avoidance and 21

evasion, if we think of the cash economy, the cash 22

economy is a disaster under all systems. And that's 23

the same entities that aren't reporting the income are 24

also probably not paying payroll taxes, are also not 25


143

reporting on the sales because if they reported one, 1

they may well be caught on all. And although there 2

are ways one can get at that better and worse, that 3

basically is not an area one can make much progress 4

on. 5

Another thing that I think is helpful to 6

think about that was suggested by a number of your 7

specific points is that certain areas, like certain 8

clusters of tax expenditures that have nothing 9

particularly to do with whether you have an income tax 10

or a consumption tax, which is a lot of them, many of 11

them are not greatly affected, for better or worse, in 12

any respect, by which system you're under and whether 13

one is going to attack them, whether one politically 14

can attack them, whether one should attack this one or 15

that one. Those debates I think are largely held. 16

So I think it's important to keep focus on 17

that it really has to do primarily with taxing capital 18

income and different ways of taxing capital income. 19

It is certainly the case that if you are -- I mean, 20

certain kinds of systems, so a certain personal cash- 21

flow consumption tax, where everything is fully 22

integrated. If unlike in certain other systems, which 23

have simplicity benefits, you are funneling it all to 24

whether individuals make final consumption decisions, 25


144

certain categories become less important. 1

But, like with the wages, it would have 2

been nice to tax the wages at the source because you 3

wouldn't have to follow it later. So I think that's 4

a common sort of trade-off. 5

MR. GALE: One of the nice things about a 6

consumption tax is that it takes areas of the income 7

tax that are considered a tax shelter and makes it the 8

normal treatment. It is like reducing crime by 9

saying, "We're not going to define this activity as a 10

crime anymore." 11

I think in terms of difficult -- 12

CHAIRMAN MACK: It has been suggested that 13

that might be a bad analogy, but that's okay. 14

(Laughter.) 15

MR. GALE: It never seems to go over very 16

well. The difficult areas in the existing system, the 17

really good, I think are the financial sector, which 18

you mentioned, and then two sectors that really 19

haven't come up yet today in this panel, which is 20

international foreign income flows, and corporate 21

shelters. 22

And I, frankly, don't know enough about 23

either of them to opine confidently except that they 24

strike me that they are really important tails that 25


145

could well wag the tax reform dog here. I would 1

encourage you to pay attention to them, either in the 2

income tax or in a consumption tax system. 3

MR. ENTIN: There was an effort a few 4

years ago in one of the flat tax submissions to simply 5

get rid of the international section. It's a 6

territorial tax. And they deleted that section of the 7

code that dealt with international. 8

Unfortunately, they also deleted the 9

definitions of what was domestic and what was 10

international in the process and had to be reminded by 11

the tax counsel to put it back in. These problems 12

arise in all kinds of systems. And you do have to pay 13

attention to them. 14

They do arise more perhaps when the tax is 15

attempted to be collected at the business sector. And 16

if you can pass it through to the individual, some of 17

it does go away. So I would urge you to look at that 18

very closely. 19

In the flat tax submission, as it was 20

originally planned, they did not know what to do with 21

the banks, the insurance companies, and so on. And 22

the Europeans leave them out of the VATs for that 23

reason. 24

It is perfectly all right if you are going 25


146

to keep a business sector tax to have a VAT type for 1

most industries and then leave the financial sector 2

the way it is and just keep your boundary conditions 3

clean because you can have a neutral tax under either 4

type of situation and you can have two neutral taxes 5

side by side, one for one sector and one for the 6

other, again as long as you are careful, and still 7

handle the financial sector. But it has to look very 8

much like the current tax system. 9

MEMBER LAZEAR: All of you mentioned 10

stability in your discussions. And Mr. Gale talked 11

specifically about it by saying that there were larger 12

effects of instability on savings and investment in a 13

consumption-based tax than with an income tax. 14

I wonder if you would comment a little bit 15

on the differences in the stability of the two 16

different systems. So if we thought about, say, a VAT 17

and looked at how that was likely to be changed over 18

time versus income taxes and how that would likely be 19

changed over time? 20

Are there different incentives, both 21

political and incentives in the private sector, that 22

might be involved in thinking about the different 23

kinds of taxes that you have talked about today? 24

MR. GALE: It is a really good question. 25


147

We can look I think to Europe for some guidance on 1

what happens to value-added taxes. And there seem to 2

be two things. One is they go up. And two is they 3

get more product exemptions. 4

I guess three is there are two ways to run 5

a value-added tax, a credit invoice, which is where 6

you get a credit for taxes paid on earlier purchases, 7

or a subtraction method, where you deduct the actual 8

purchase. 9

I think most American economists like the 10

subtraction method because it is simpler, but every 11

European country has a credit invoice method. And the 12

reason is that you can do special preferred treatment 13

of different goods and services that way. Politically 14

that is an advantage. Economically it is probably 15

not. 16

So I think that is the way the VAT would 17

go. The income tax, we have seen how it goes, up and 18

down and with increasing tax expenditures over time. 19

So I don't see why that would change. 20

MR. ENTIN: Who are we trying to help: 21

people or federal budget writers and the members of 22

Congress? 23

MR. KAPLOW: They are people, too. 24

MR. ENTIN: They are people. They have a 25


148

peculiar outlook on the world, however. Consumption 1

is less likely to fluctuate, even in a downturn, than 2

would investment spending. Investment spending goes 3

through the big cycles. So in a sense, the 4

consumption base is a stabler base given whatever 5

happens in the economy than is an income tax base. 6

Congress has, of course, reacted to that 7

through the corporate AMT, which says that, even in a 8

recession, you have to pretend your income is higher 9

than it really is and continue paying. And we'll give 10

it back to you later on when your income goes back up 11

and you have gone back into the ordinary tax system. 12

So Congress does take measures to protect 13

itself from fluctuations in revenue when, in fact, the 14

government with its perfect credit rating should be 15

the one to take the hit when there is a downturn, 16

sometimes caused by federal policy. 17

So I would suggest to you that the tax 18

system, either over business cycles or between 19

products, should remain a steady and unbiased, no 20

exemptions from the VAT if you have one, no peculiar 21

rules that kick in during recessions to change the tax 22

treatment of businesses that tend to worsen 23

recessions, by the way, none of that. 24

Let the government go through the roller 25


149

coaster. Let the government borrow when it has to and 1

pay down debt when it can. But don't keep changing 2

the rules on the private sector. It is not a good 3

idea. 4

MR. KAPLOW: It is not clear to me how 5

much difference there is under the two systems with 6

the political forces. I mean, I think Bill's 7

observation about European VAT is certainly correct. 8

You go for product areas of expenditure. But you can 9

just see how seamlessly one can move between one and 10

another. 11

So under an income tax, if we want to help 12

people who are sending their kids into higher 13

education, we enact a savings goodie. If we had a 14

consumption tax, well, since we're giving that savings 15

treatment to everything now, that would not be the 16

natural way to go. 17

But just on the direct outlay, we could 18

provide a preference of similar magnitude. It might 19

be simpler, which might be good. It might be simpler, 20

which might be bad, because more of it would creep in, 21

even when it doesn't necessarily make sense. 22

I think there is a sense in which many of 23

the forces in a fairly one to one way would migrate 24

from one to the other and, for better or worse, play 25


150

themselves out in a similar fashion. 1

MR. ENTIN: These reforms are all better 2

if Congress, either on the outlay side or in the tax 3

side, would meddle less in people's decisions and just 4

get out of the way and let people order their lives 5

the way they see fit. Then many of these 6

complications in either system would simply go away. 7

CHAIRMAN MACK: Many businesses believe 8

that the U.S. tax system makes them less competitive 9

at home and abroad against foreign-based 10

multinationals. How would a tax on consumption affect 11

the competitiveness of U.S. companies? 12

I think I'll keep it at that. I mean, 13

there is this whole issue, I guess, of border 14

adjustments and so forth. So whoever wants or all 15

three can respond to that. Anybody want to take it? 16

After you. 17

MR. ENTIN: I hope none of my donors are 18

listening. Economists generally believe that the 19

advantages of the consumption-based taxes are that you 20

have stripped away the excess layers of tax on capital 21

formation. You have gone to expensing. You don't 22

double tax the corporate income. And there is no bias 23

against saving. This lowers the cost of capital. 24

You would have a lot more investment in 25


151

the United States. The capital stock would be much 1

higher. Workers would be more productive. And they 2

would be paid for their productivity increase. Everyone 3

would be better off. 4

Whether this would change the competitive 5

picture of American businesses vis-a-vis some other 6

country is not something an economist cares about 7

because if we are bigger, then we are fine, whether 8

there is the rest of the world out there or it doesn't 9

even exist. We're better off not discriminating 10

against domestic growth. 11

The question then arises with some of 12

these taxes, does border adjustability add anything 13

over and above the fact that you have gone to 14

expensing and stripped off the double taxation of 15

capital? Economists would generally say no. The 16

benefit of going to the consumption base is that you 17

have lowered the cost of capital. 18

The border adjustment runs into many 19

descriptions that say it is going to be better for 20

you, but it really can't work. And the reason 21

economists say it can't work is as follows. You often 22

hear, well, it's because exchange rates adjust. Well, 23

yes, they do, but that is just the transmission 24

mechanism. 25


152

What is really happening is this. Suppose 1

I suddenly go to a tax system where I am not taxing 2

exports and I am taxing imports and I try to produce 3

more for exporting and supposedly I am not going to be 4

buying the imports. My population is being paid, 5

nonetheless. They're producing something, and they're 6

selling it. They're going to get the same income. 7

If now we take a chunk of our output that 8

we were producing for domestic use and send it 9

overseas but we still have the same income, I am still 10

going to want to buy that stuff I was previously 11

buying that we have now shipped to Europe. It's gone. 12

What am I going to buy instead? I'm going to be 13

buying European products that they had to sell to us 14

to earn the dollars to buy what we just sent to them. 15

You may get more exports, but if you do, 16

you're going to get more imports or the exchange rate 17

may adjust and you don't get more exports and you 18

don't get more imports. Theoretically there is no 19

distinction in terms of total economic activity, 20

whether the thing is border-adjustable or it isn't. 21

If you have different situations in 22

particular industries, where elasticities of this and 23

that may vary, you may get some situation. In the 24

VAT, for example, if the financial sector is exempt, 25


153

you may get a distinctive twist in the relative 1

competitiveness of the manufacturing sector versus the 2

financial sector. And there may be some shuffling of 3

resources. 4

In the large, it shouldn't have a major 5

effect. If you're already at full employment, how are 6

you going to get more employment, for example? I 7

mean, there is another question to ask. Why would it 8

make a difference? 9

In the several kinds of consumption-based 10

taxes, two of them are explicitly border-adjustable. 11

The retail sales tax obviously is on whatever you buy 12

at the store: import and the domestic product. 13

And the export doesn't go through retail. So it's 14

gone, not taxed. 15

VAT does the same thing. It's adjustable 16

at the border. But think of the VAT tax, if you will, 17

or think of the consumed income tax, which is your 18

revenue minus your saving. Revenue minus saving is 19

what you take to the store. 20

Now, I'm already going to pay tax on it 21

before I leave the house because it's collected at my 22

household level. But now that I have taken my 23

after-tax income to the store, whether I buy an import 24

or I buy a domestic product, I have already been taxed 25


154

on my income. So in a sense, it's implicitly but not 1

explicitly border-adjustable. 2

So I wouldn't worry about which of those 3

varieties of consumption tax that you pick vis-a-vis 4

its effect at the border. If the businesses' 5

community is correct that it somehow is going to boost 6

exports, well, it will under either system, either 7

topic that's on the base tax. If it's not going to 8

boost exports, while it won't under either type of 9

consumption-based tax. 10

And basically just remember no one is 11

going to give us something for nothing. If we're 12

going to sell more to them, they're going to have to 13

sell more to us. 14

What I do hear often is that somehow we're 15

going to solve our balance of payments problem by 16

going to a border-adjustable tax. If you go to any 17

tax which increases investment in the United States, 18

which a neutral tax would do, it's a race. Will 19

domestic saving go up to cover it or not quite go up 20

to cover it? 21

Because if investment rises by more than 22

saving, we're going to attract more capital. And if 23

the saving rises by more than investment, we're going 24

to need less foreign capital. 25


155

The movement and the balance of payments 1

on goods and services will be in the opposite 2

direction and of equal size to the movement and the 3

capital flow. 4

If you make the United States the better 5

place in which to invest and attract more foreign 6

capital, we're going to have a worse trade deficit. 7

But we're going to be growing faster. And everything 8

we produce is going to be bigger until the adjustment 9

takes effect and we go back to normal. 10

I think the long-term problem we need to 11

look more at is that the fuss is over manufacturing. 12

We are becoming more of a service economy, less of a 13

manufacturing economy. People are upset. 14

There is a bias in the income tax against 15

manufacturing, which tends to be capital-intensive 16

relative to the financial sector and the service 17

sector. And that is because we don't allow a full 18

present value write off of the cost of plant and 19

equipment because we do depreciation, instead of 20

expensing, because we have a higher cost of capital 21

due to the structure of the income tax. 22

If you went to a neutral tax system, you 23

would probably see a little bit of a bump up in 24

manufacturing, a little bit of reduction in the 25


156

service sector until that adjustment was completed and 1

then trend growth and both. 2

That is not because of border adjustment. 3

That is because of the nature of the income. And that 4

would be benefitted by moving towards these neutral 5

systems, even if there were nobody else in the world. 6

So listen to the arguments. Bear in mind 7

they probably don't matter. And then do what you 8

think best as long as it's neutral somehow. 9

CHAIRMAN MACK: That was quite an ending 10

to that, Steve.11

Bill, do you want to? 12

MR. GALE: Sure. Just real quickly, I 13

talked to someone in the White House, asking them 14

advice about what I should say to the Tax Reform 15

Panel. And they only had one thing to say, which is 16

don't mention border adjustability. So I'm not going 17

to go there. 18

But I do think that to the extent that 19

competitiveness is a goal, there are lots of other 20

tools besides tax policy. Fiscal policy and its 21

impact on the dollar, R&D policy, education policy, 22

you know, infrastructure can all make a difference. 23

And I'm a card-carrying economist. 24

Therefore, I agree with Steve that border 25


157

adjustability is not an issue. But I understand that 1

is not a compelling argument to the millions of people 2

that think it is. And I would encourage you to 3

actually have a session that goes through this and 4

tries to nail it down. 5

MR. KAPLOW: I have very little to add to 6

that because there are some things economists agree 7

on, at least a few. And this is certainly one of 8

them. 9

But an aspect of something that Steve 10

mentioned, just to embellish it a little bit, at the 11

end of the day, if our nation is able to enact a tax 12

reform that eliminates economic distortions in the use 13

of capital in the organization of firms, which is part 14

of how the distortions are manifested, that will 15

enhance productivity. That is a gain. 16

Now, a question we can ask, you know, 17

"Will those in Europe, Japan, or China mimic us to the 18

extent they are not already ahead of us?" 19

Fortunately, in many respects, they're not. They may 20

or may not. 21

We can also ask, since we're talking about 22

an integrated system, how does the taxation of 23

corporations relate to that of individuals and so 24

forth, when you then get corporations that are 25


158

foreign-owned but located here, the question of how we 1

are going to take any reform that we apply within our 2

borders and apply either to foreign corporations 3

operating here or to U.S. investment abroad, which is 4

the international dimension of the system, those are 5

things we want to worry about getting right that can 6

have effects. 7

If we extend a more efficient system to 8

foreign capital operating here, that will help the 9

owners of that capital, which are people in other 10

countries, but will also enhance that productivity of 11

their capital in the U.S., which we might think is a 12

good thing and we might not want to cut off our nose 13

to spite our face in a situation like that. 14

So on the international sides in both 15

directions, there are pieces that have to brought in, 16

for whatever one will do, but I don't think any of 17

this is tipping against. It's really operating on a 18

different dimension from the overall statements about 19

how capital and trade flows in and out, how prices, 20

exchange rates adjust, and whether this is something 21

really to worry about or not. 22

MR. ENTIN: I do apologize. None of us 23

answered the other half of your question, which was, 24

what happens to American firms working abroad 25


159

vis-a-vis other firms abroad and they are trying to 1

impose our tax rate structure on them when their 2

competitors abroad don't face our tax rate structure? 3

That can indeed mean that our companies 4

have a harder time in a third country than other 5

countries' home-based countries. And that I think is 6

why you have deferral and why you have firms treated 7

the way they are overseas. 8

In a territorial system, you would simply 9

clean that all up. And we wouldn't be imposing our 10

tax structure on the firm for an affiliate abroad. 11

And they could compete in Ireland. They could compete 12

in France with French and Irish and German and British 13

firms on a level playing field. 14

When they can, they tend to use more 15

services from the home company here. They tend to buy 16

more from the home company here. It's probably a gain 17

to us. And it's also fairer treatment. 18

CHAIRMAN MACK: Good. Well, several of us 19

have over the years participated in lots of hearings, 20

but I want to suggest that the four of you have been 21

outstanding today. I think that the dialogue that has 22

developed, as opposed to just kind of engaged in sharp 23

questioning, has really again provided us with lots of 24

very useful information. 25


160

So I do appreciate the time and the effort 1

that you all have put into both preparing your 2

thoughts for today and for your open dialogue with us 3

about the issues that we have raised. So thank you 4

very much for that. 5

I would also just say that we are going to 6

have another hearing on Thursday, March the 3rd at 7

9:30 a.m. It will be held here in Washington at 8

George Washington University. The topic will be 9

perspectives on tax reform and continued examination10

of the problems in our current tax system. And we'll 11

release the names of those who will be participating 12

in the panels a little bit later. 13

With that, I also want to thank the panel 14

for your time and your effort this morning. At this 15

point, this hearing is adjourned. Thank you all very 16

much. 17

(Whereupon, at 1:09 p.m., the foregoing 18

matter was adjourned.) 19

20

21

22

23

24

25

Opening Statement

Federal Tax Reform Panel

Elizabeth Garrett*

February 16, 2005

In his State of the Union address, President Bush set out three objectives

for tax reform: “pro-growth, easy to understand, and fair to all.” Since the

enactment of the Tax Reform Act of 1986, we have been moving farther away

from its goals of fairness and simplicity with each succeeding tax bill. I am

looking forward to working with my colleagues on the Tax Reform Panel to find

our way back to a fairer, less complex system of raising revenue, one that also

ensures strong economic growth and international competitiveness for our

country. As we examine how to assemble changes to the tax system that

promote growth, fairness and simplicity, we need to keep several goals in mind.

First, we need to think about incentives. We have long used the tax code

as a way to encourage people and businesses to create value for our economy

* Sydney M. Irmas Professor of Public Interest Law, Legal Ethics, and Political Science, University

of Southern California; Director, USC-Caltech Center for the Study of Law and Politics.

University of Southern California Gould School of Law

and society. I am sure that any reform proposal we bring forward will include

some such provisions; indeed, the Executive Order that established our Panel

directed us to recognize “the importance of homeownership and charity in

American society.” As we consider which tax expenditures should be retained,

which should be expanded, and which should be eliminated, we must keep in

mind that tax expenditures are only justified when they actually change behavior

in the way we intend it to change. It is not worth the revenue loss if a tax

expenditure subsidizes behavior that would occur even without the tax incentive;

all that happens is that we create a windfall for a few at the expense of all

taxpayers. Fortunately, we have data about the effect of tax expenditures that

have been in the code for years, and I look forward to carefully scrutinizing that

data so that we are certain every tax subsidy we support is likely to produce its

intended effects.

Second, we need to remember fiscal discipline. As we go about our work,

we must keep in the forefront of our minds that the tax system is primarily

designed to raise revenue to support the activities that the federal government

engages in – both at home and abroad. Our proposal is supposed to be revenue

neutral, that is, to raise the same amount of money as the current tax system

raises. Some tax reform proposals that we are likely to consider may not result

in immediate revenue loss, but over time they will substantially reduce the

revenue that the federal government collects. We cannot focus only on the

short-run and leave the next generation to face dire fiscal realities. Given the

current federal fiscal situation, with a deficit estimated at around $500 billion in

fiscal year 2005, as well as with looming shortfalls in the entitlement programs –

Medicare and Social Security – we have a profound obligation to recommend

changes that are fiscally prudent not just in the next five or ten years, but also in

the long term. We must be aware that the fiscal health of the country is much

more dramatically affected by revenue decisions and decisions about entitlement

programs than it is by spending through the annual appropriations process.

Third, we must remember that progressive rates are not the only important

feature of a tax system that is designed to be “fair to all.” The goal of fairness is

concerned with how the tax system treats people in different circumstances. We

need to recognize that in our complex society, taxes can be unfair not only when

they fail to take into account differences in income levels. We need to consider

fairness across differences in tax status, looking at whether some tax credits

should be refundable to provide incentives to those without tax liability as well as

to those who owe taxes. We must consider what is fair across differences in

marital status, determining the right structure to tax married couples when both

work and earn income. We need to think about how to fairly balance the tax

burden on income from wages – already burdened by payroll taxes – with the tax

burden placed on income from savings and investment.

Fairness also implicates issues of transparency. Citizens must

understand, in at least a general way, how they will be taxed. It is not fair, for

example, to surprise them with an alternative minimum tax that was designed

only to apply to the very wealthy in our country, but which is now projected to

apply by 2010 to more than 34 million Americans, many of them families with

relatively modest incomes.

These are some of the issues, among many, that I hope we will address in

our work. I am looking forward to the next few months of discussion and analysis

and to bringing forward options for reform that are consistent with the President’s

goals, and with the goals we all share for a better, fairer tax system.

IRET Institute For Research OnThe Economics Of Taxation

IRET is a non-profit 501(c)(3) economic policy research and educational organization devoted to informingthe public about policies that will promote growth and efficient operation of the market economy.

1710 RHODE ISLAND AVENUE, N.W. • 11th FLOOR • WASHINGTON, D.C. 20036 • (202) 463-1400 • www.iret.org

REFORMINGREFORMING TAXATION:TAXATION:ADVANTAGESADVANTAGES OFOF AA SAVING-CONSUMPTIONSAVING-CONSUMPTION NEUTRALNEUTRAL

TAXTAX BASE,BASE, ANDAND PRINCIPLESPRINCIPLES TOTO GUIDEGUIDE REFORMREFORM

Statement toThe President’s Advisory Panel on Federal Tax Reform

by Stephen J. EntinPresident and Executive Director

Institute for Research on the Economics of TaxationFebruary 16, 2005

President Bush has called for wide-ranging tax reform and simplification. He is askingfor a tax system that is more pro-growth, that is simpler, and that is fairer than the currentsystem. The possibility of real tax reform is higher now than at any time since 1986.Consequently, it is an honor and a privilege to be asked to testify before the Commission, andI thank you for the opportunity.

I have been asked to discuss the advantages of a tax system that is neutral in its treatmentof income used for saving and for consumption, sometimes referred to as a consumption-basedtax. A neutral tax treats all economic activity alike, and avoids the anti-saving biases in thebroad-based income tax. A neutral tax would be simpler, more pro-growth, and, in my view,more uniform and fairer than the current tax system.

IRET <www.iret.org> has published several papers on the advantages of neutral taxsystems and their economic impact which would be useful for the Commission to review.

• The Inflow-Outflow Tax1 <ftp://ftp.iret.org/pub/InflowOutflowSum.PDF>, which we view asthe optimal neutral tax system.

• The Economics of Taxation and the Issue of Tax Reform2 <ftp://ftp.iret.org/pub/EntinNewOrl-2003.PDF>, a handbook on the way in which taxes affect the economy, the conceptof marginal tax rates and a non-distorting tax base, the anti-saving, anti-investment features ofthe current income tax, and the advantages of neutral taxation.

• Reforming Taxation: Attributes of a Good Tax System and Principles to Guide Reform3

<ftp://ftp.iret.org/pub/ADVS-183.PDF>, some basic facts on the purposes of taxation, and thenature of income, fairness, and efficiency that should be understood in order to develop a goodtax system.

ftp://ftp.iret.org/pub/InflowOutflowSum.PDF

www.iret.org

ftp://ftp.iret.org/pub/EntinNewOrl-2003.PDF


ftp://ftp.iret.org/pub/ADVS-183.PDF

• Renew Bonus Expensing To Keep Recovery Strong4 <ftp://ftp.iret.org/pub/ADVS-173.PDF>,showing the sensitivity of investment to tax treatment.

• The End of Tax Expenditures As We Know Them?5 <ftp://ftp.iret.org/pub/BLTN-84.PDF>,which warns that what is an anomaly under the income tax, and may have been branded a taxexpenditure, may be the highly desirable norm under a consumed-income or consumption tax(example, all pension and retirement plans).

• Tax Incidence, Tax Burden, and Tax Shifting: Who Really Pays the Tax?6

<ftp://ftp.iret.org/pub/BLTN-88.PDF> which demonstrates that all taxes are paid by individuals,that taxes on corporations and capital income in general are largely shifted to labor by depressingsaving, investment, productivity, and wages, and that graduated tax rates on the upper incomeresult in lower incomes across the board.

• Phase-outs Increase Tax Rates and Tax Complexity7 <ftp://ftp.iret.org/pub/BLTN-71.PDF>which calculates the adverse impact on marginal tax rates of many tax provisions that means testdeductions, credits, and exclusions.

• Taxes and the Good Society8 <ftp://ftp.iret.org/pub/TaxesGoodSoc.PDF>, which is a discussionby the late Dr. Norman B. Ture, one of the country’s leading tax experts, on the basic conceptsof tax fairness, neutrality, and the purpose of taxation in a democratic society.

What is the current system?

The current federal income tax system is a hybrid. It begins as a broad-based income tax,which is a type of tax that falls more heavily on income used for saving and investment than onincome used for consumption, chiefly by subjecting saving and investment to multiple layers oftax. However, the current system contains provisions that treat a portion of saving andinvestment as they would be treated under a saving-consumption neutral system (or consumption-based system), in order to moderate the damage that would otherwise be done.

The current system taxes the world-wide income of U.S. residents (a global system),requiring offsetting credits for foreign taxes paid to avoid double taxation. The simpleralternative would focus on activity within the United States (a territorial system). Thesefumblings and compromises have added greatly to the complexity of the tax system. A clean andsimple neutral territorial tax system would achieve these objectives much more easily.

Why tax reform? Income, growth, and jobs.

The current tax system distorts economic activity and reduces income and employment.It does so to the degree that it is closer to a broad-based income tax than to a neutral orconsumed-income tax. It hides much of the cost of government from the taxpayer-voters. It iscomplex, making it expensive and confusing to comply with, and hard to enforce. It is subjectto abuse by taxpayers and the IRS. It breeds suspicion, because people do not see clearly whois paying the tax, and is widely viewed as unfair, although definitions of fairness vary.

2


ftp://ftp.iret.org/pub/BLTN-84.PDF



ftp://ftp.iret.org/pub/TaxesGoodSoc.PDF

We could end most of these distortions, complications, and suspicions by moving to asaving-consumption neutral tax. Such a move would improve the economy, raise incomes, andpromote employment. The shift would have the added benefits of simplifying compliance andenforcement, enhancing transparency and confidence in the system, and reassuring people as tothe fairness of the tax system.

Any of the several types of neutral tax system would be more conducive to capitalformation than current law. They would all allow the economy to operate more efficiently andto gain, over about a decade, the investment that the current biased tax system has suppressed.I estimate that they would add about 10 percent to the GDP, or about $4,000 to $6,000 toaverage family income. The various neutral taxes take different approaches to eliminating thebiases in current law, and provide differing degrees of simplification and transparency. Theymay differ in transition issues. But all would raise incomes and employment.

Other things equal, each time in the past that the United State has moved its tax systemaway from the income base toward the consumption base, it has seen, as of the dates when thechanges became effective, improved levels of saving and investment, productivity, and wages.Each time that tax policy has shifted back toward the income base, with higher taxes on capitaland steeper tax rates on those who produce the most, economic performance has deteriorated.The Tax Acts of 2001, 2002, and 2003, which reduced marginal tax rates and reduced the doubletaxation of corporate income, moved the United States toward a consumption base, and havegreatly strengthened the recovery from the last recession. The Tax Reform Act of 1986 was ashift toward the income tax. It raised taxes on capital and was followed by a major stock marketand real estate collapse. That "reform", plus two subsequent payroll tax increases, paved the wayfor the subsequent recession.9 The same phenomena have been observed internationally. Japanmimicked the 1986 U.S. reform in 1988, curtailing tax-neutral saving plans, instituting a capitalgains tax, and raising property taxes soon after. As a result, Japan has been in a virtually non-stop recession for over 15 years. By contrast, lower corporate tax rates in Ireland and EasternEurope, and flatter individual tax rates in Eastern Europe and Russia, have greatly improvedeconomic performance.

Correcting flaws and avoiding errors.

Understanding the advantages of a neutral tax may require people to learn some newterminology, and to rethink some ideas about taxes that have been taken for granted over the past80 years. We are used to thinking in terms of the current tax system. Its definitions of incomeand its structure of taxes seem normal, even though they are often at odds with reality, logic,and sound economics.

The Commission would perform a real public service by using its position toimprove the public’s understanding of the nature of income, what constitutes a sound taxsystem in a democratic society, and the advantages of making significant changes.

The Commission should start by taking stock of the purposes and attributes of agood tax system, to give itself a standard against which to judge the many proposals itwill consider.

3

The Commission should consider how a revised tax system could promote goodgovernment by making the tax system more transparent to the voters and less susceptibleto manipulation by special interests, either commercial or political.

The Commission must make an explicit choice early on about what it considers tobe the right type of tax base. Until the appropriate concept of a tax base is selected, nodecision about specific deductions, credits, exclusions, inclusions, or points of collectioncan be made in any sensible, consistent manner. A deduction or exclusion that may benatural under one tax base may be incorrect or distorting under another. If someone tellsyou that something is a "tax expenditure", ask him, "In which tax system?"10

The Commission should make sure that the steps it recommends would improve thefunctioning of the economy and raise the level of employment, output, and income.Otherwise, there is not much point.

In particular, the Commission must be aware of whether or not the reforms that itis considering would move in the direction of a more neutral tax base and lower the"hurdle rate" or cost of capital compared to current law. A neutral tax with a lower costof capital would increase capital formation, productivity, and per capita output andincome. If it does not take this precaution, it may stumble into recommendations thatwould reduce growth and job creation.11

The Commission must consider how the tax is to be collected and administered.There are trade-offs between a tax that is highly visible and transparent to the voters, andone that is simpler to comply with but less informative of the cost of government.

The Commission should also review the basic concepts of fairness and efficiencyin taxation, to ensure that they reflect the nature of production and income. TheCommission should think though these fundamental issues before making decisions on thedetails and minutia of the new tax code.

Toward that end, I offer the following framework to guide the development ofalternatives to the current tax system.12

Framework for thinking about tax reform.

What are the two main purposes of a sound tax system?

1. Raising revenue to pay for government goods, services and activities; and

2. "Pricing" government to let people know how much they are being charged forgovernment goods and services so that, as taxpayers and voters, they may decide in aninformed manner how much government activity they wish to support with their votes.

The current federal tax code fails to accomplish these purposes in an effective andefficient manner.

4

What Is Income? Income is earned. Income is the reward for supplying labor andcapital services to the market to create goods and services of value to others. Except inrare instances, income closely matches the value of the effort and services provided byindividuals to produce additional output. Supplying labor and capital means giving upleisure and deferring consumption. These sacrifices are the cost of earning income.These attributes of income have important implications for the concept of fairness and thedesign of the tax system.

Income is a net concept: revenues less the cost of generating those revenues. Justas a business cannot reasonably be said to have a profit until its revenues exceed its costsof production, neither can a worker or saver be said to have income until his revenuesexceed the amounts spent on acquiring the skills (through education) or purchasing theassets (through saving and investing) that generate the revenues. To obtain a realisticmeasure of a person’s income, the full value of all costs of earning revenues (includingeducation expenses, saving, and investment outlays) should be subtracted from revenues.All returns from such efforts that exceed these costs (including withdrawals of deferredprincipal and its earnings) should be added to revenues.

Who Pays Taxes, and With What? In reality, only people pay taxes, and all taxesare paid out of income. Goods and services do not pay taxes; businesses do not pay taxes.Taxes collected by businesses fall in reality on the income of the businesses’ shareholdersor other owners, lenders, workers, or customers in the form of lower returns, lower wagesand/or higher prices. This insight has implications for the design of the tax system, andwho is responsible for collecting and sending taxes to the Government.

Four key criteria for tax reform.

Tax reform should be approached with four criteria in mind: neutrality, visibility,fairness, and simplicity. Fortunately, to a great extent, simplicity, neutrality, and fairness(properly defined) can all be achieved at once by means of saving-consumption neutraltax systems.

Neutrality. Neutrality is essential if the economy is to operate at peak efficiency,and if incomes are to be as high as possible. Strict neutrality requires that income becalculated correctly and then taxed at a uniform rate.

The tax system should be even-handed or neutral across various types of saving andinvestment, and between saving and investment and consumption. That can be achievedby treating saving and investment as costs of earning income. All saving must receive thesort of tax treatment currently afforded pensions, various types of IRAs, 401(k), Keough,SEPs, and other saving-deferred plans currently in the tax code. Investment outlays,research and development expenses, and purchases of inventories must be deducted in theyear the outlay is made (expensed), rather than depreciated over time. Failure to do so,as in the income tax, raises the cost of saving more than it raises the cost ofconsumption.13

5

Neutrality also means that multiple layers of tax on capital must be avoided. Inparticular, the dual taxation of Schedule C corporate income at the corporate andindividual level must be eliminated. The transfer tax on estates and gifts must also beremoved, because an estate is saving that has already been taxed or will be subjected tothe heirs’ income tax.

Visibility. Visibility means a tax system is transparent to the taxpayers so it isclear how much government costs and who is paying for it. Visibility is necessary forvoters to determine when the benefits of government spending are sufficient to match itscosts. Visibility is a key element in holding government accountable to voter-taxpayers.

Visibility is best achieved by a tax levied as openly as possible with some form ofannual accounting that confronts individuals with the full amount of taxes they have paidover the course of the year. Visibility suggests that revenues not be collected from taxesburied in businesses transactions.

Visibility also requires that as many people as possible be subject to tax, exceptingonly the very poor, so that they can see that government is not a free good. It should notbe possible for a majority of voters to shift a disproportionate share of the tax burden ontoa minority of taxpayers.

Visibility can reassure people about the fairness of the tax system. If everyonewere filling out the same simple tax forms, and people could understand what was onthem, then people would be far more certain that they and their neighbors were payingtheir fair share of taxes. The mystery and the suspicion would be gone.

Fairness. Fairness means equal treatment under the law, and respect for thepeople who produce goods and services. Income is the earned reward for contributing tothe production of goods and services. This fact, combined with the principle of equaltreatment under the law, strongly urges that a proportional (single-rate) tax on income isthe fairest.

Compassion requires that the very poor be relieved of the burden of paying for theprotections afforded by government and for the public goods and services provided bygovernment that they and their families consume. But insofar as possible, it is fair thateveryone should contribute something toward these communal efforts.

Allowing all individuals, regardless of income, an equal personal exemption isconsistent with this concept of fairness. It would provide that persons of higher incomepay a higher fraction of their income in tax than persons of lower income, but not in agreatly disproportionate manner.

Simplicity. The complexity of the current tax system imposes enormouscompliance costs on taxpayers and enforcement costs on the government. Most of thecomplexity in the current tax code stems from its arbitrary definition of taxable income,

6

its effort to impose non-neutral taxation of income from capital, and its taxation of incomefrom foreign sources offset by a tax credit for foreign taxes paid.

There is no conflict between simplicity and neutrality. Neutral tax systems that arenot biased against saving and investment are inherently simpler and fairer than non-neutralones. Systems that restrict taxation to income earned domestically are likewise simplerthan systems that tax global income with a credit against foreign taxes paid. Forsimplicity, the tax system should be territorial, levied on income earned within thecountry.

However, the very simplest tax systems, those that would have businesses collectall taxes without income earners or consumers seeing what is taken or having to do anywork would be a violation of visibility.

Simplicity should not be an excuse to remove large numbers of people from the taxrolls or to eliminate periodic tax filing. Some small amount of effort by the citizens inpaying tax is a fundamental requirement of a tax system that informs the citizen-votersabout what government is doing, enabling them to fulfill their civic responsibility in ademocratic society.

The current tax code fails all four tests.

The current tax code violates neutrality by taxing some income at higher rates thanother income, in particular by falling more heavily on income used for saving andinvestment than on income used for consumption. It hides significant revenues from thevoters in business taxes, and it exempts tens of millions of people from the income taxrolls. It masks the cost of government. It encourages people to attempt to shift the costof government goods and services to others. It is enormously complicated. It punishesreal economic effort and treats many taxpayers very badly.

Let me take a moment to make clear what the income tax biases against saving andinvestment consist of. At the federal level, there is usually one layer of tax on incomethat is used for consumption, but there are at least four layers of possible tax on incomethat is saved (Chart 1).

1) Income is taxed when first earned (the initial layer of tax). If one uses the after-tax income to buy food, clothing, or a television, one can generally eat, stay warm, andenjoy the entertainment with no additional federal tax (except for a few federal excisetaxes).

2) But if one buys a bond or stock or invest in a small business with that after-taxincome there is another layer of personal income tax on the stream of interest, dividends,profits or capital gains received on the saving (which is a tax on the "enjoyment" that one"buys" when one saves). The added layer of tax on these purchased income streams is thebasic income tax bias against saving.

7

Institute for Research on the Economics of Taxation (IRET)

(Similar taxes at the state and local levels increase the multiple taxation.)

Layer 4 – Transfer (Estate and Gift) TaxAnother tax on already taxed assets.

Layer 3 – Corporate Income TaxIf the saving is in corporate stock, the corporate tax hits the income before it is either paid out to shareholders or reinvested to boost future earnings.

Layer 2 – Personal Income Tax on ReturnsIf the income is saved, the returns are taxed as interest, dividends, capital gains, or non-corporate business profits.

Layer 1– Tax on EarningsIncome is taxed when earned. If it is used for consumption, there is usually no further federal tax.

Chart 1 Multiple Taxation of SavingOne Tax on Consumption, Four Taxes on Saving


(c) Retained Earnings and

Dividends, 2003 Act

(b) Dividend Payout, Pre 2001

Act

(a) Retained Earnings, Pre

2003 Act

* Top corporate rate excludes corporate surtaxes, and top individual rate ignores phase-outs of exemptions and deductions and taxation of Social Security, which may push effective top tax rates higher than statutory rates. Retained earnings are assumed to trigger a long-term capital gain with a maximum rate of 20% or 15%. Short-term gains are taxed at ordinary tax rates.

$0.5525$0.3926$0.527) Income left to shareholder

44.75%60.74%48%6) Total tax rate

$0.4475$0.6074$0.485) Total tax

$0.0975(tax rate 15%)

$0.2574(tax rate 39.6%)

$0.13(tax rate 20%)

4) Individual income tax at top rate (dividends as ordinary income, retained earnings as capital gain)*

$0.65$0.65$0.653) After-tax corporate income:Either retained, raising stock price (columns (a), (c)), or paid as dividend (col. (b), (c))

$0.35$0.35$0.352) Corporate tax at top rate

$1.00$1.00$1.001) Corporate Income

Chart 2 Multiple Taxation of Corporate Income

3) If the saving is in corporate stock, there is also the corporate tax to be paidbefore any distribution to the shareholder, or any reinvestment of retained after-taxearnings to increase the value of the business. Whether the after-tax corporate income ispaid as a dividend, or reinvested to raise the value of the business and create a capitalgain, corporate income is taxed twice — the double taxation of corporate income.

4) If a modest amount is left at death (beyond an exempt amount that is barelyenough to keep a couple in an assisted living facility for a decade), it is taxed again bythe estate and gift tax (the "death tax").

State taxes compound these biases.

The anti-saving and anti-investment biases in the income tax retard growth. Themaximum combined federal corporate and individual income tax rates on dividends couldexceed 60 percent before the 2003 tax reductions, and they are still are nearly 45 percenttoday (Chart 2). That is before state and local taxes, and is on top of the tax on theincome that was used for the saving. Estate taxes and the generation skipping tax can stillraise the total tax burden on income going into a taxable estate to between 80 and 85percent. The tax disincentives to save and invest, and to work, train, and take risks, leadpeople to under-save and over-consume, and to work less and play more.

It has long been assumed that high graduated tax rates and added layers of tax onincome used for capital formation would do little economic damage, would harm only thewealthy, and would provide significant income redistribution. In fact, incomeredistribution was the main justification for the "Haig-Simons" definition of income thatinspired the concept of taxable income in the current income tax. Professor Simons, atleast, admitted that the tax was not economically optimal, and that it would damage savingand reduce output. His disciples seem to have forgotten that consequence, and are livingin a state of denial.14

It has become apparent, however, that most of the taxes that seem to fall on thosewho supply physical capital, intellectual capital, or special talents to the productionprocess may actually be shifted to ordinary workers and lower income retirees in the formof reduced pre-tax and after-tax incomes. Even for labor, the optimal (additional) tax onthe normal returns to capital is zero.15

Capital is far more sensitive to taxation than is labor (Charts 3 and 4). Saverscan easily switch to consumption, a satisfying alternative, or send capital abroad. Manyworkers, by contrast, have to work to make ends meet, or work hours that are set by theiremployers. (The self-employed or the upper income, who can afford to retire or take timeoff, have somewhat more flexibility as to hours worked.) Therefore, a given tax rateimposed on labor and capital has a far greater impact on the quantity of capital than thequantity of labor offered to the market. The relatively large reduction in the in the stockof capital depresses productivity and demand for labor, which lowers wages andemployment. The work force bears the economic burden of taxes on capital (Chart 5).

9

Desired Amount of Capital

Ret

urn

to

Cap

ital

Chart 3 Effect of Tax On Desired Capital Stock

Net Return

Gross Return

Required Return to Capital (Supply)

Tax

Drop in Capital

K' K

Marginal Product of Capital (Demand)

Hours Worked

Wag

e

Chart 4 Effect of Tax On Labor

Labor Supply

Net Wage

Gross Wage Marginal Product of Labor (Demand)

Tax

Dropin

Labor

L' L

MPL would rise if there were more

capital to work with, and fall if

capital formation lagged.

Employment

Wag

eLabor Supply

MPL (K0)

W

N1

MPL (K1)

W1

N0

Chart 5 A Smaller Stock Of Capital Reduces Wages

Consider a small trucking company with five vehicles. Suppose that the rules fordepreciating trucks for tax purposes change, with the government demanding that thetrucks be written off over five years instead of three. The owner has had enough businessto run four trucks flat out, and a fifth part time. He is barely breaking even on the fifthtruck under old law. It is now time to replace one of the trucks. Under the new taxregime, it does not quite pay to maintain the fifth truck. The owner decides not to replaceit, and his income is only slightly affected. But what happens to the wages of the fifthtruck driver? If he is laid off, who bears the burden of the tax increase on the capital?

Consider another example, involving human capital, specifically, medical training.Suppose the imposition of a progressive income tax were to discourage the supply ofphysicians by inducing some doctors to retire, by causing others to work fewer weeks peryear, and by dissuading people from applying to medical school. One result would befewer jobs available and lower levels of productivity and incomes for nurses and supportstaff in medical offices and hospitals. Another would be a rise in the price of health carefor consumers (including the government).

Neutral taxes can be best at satisfying the four key criteria for a good tax system.

Neutrality and Growth. Neutral taxes are, by their nature, more favorable towardgrowth than income taxes. Neutral taxes eliminate the income tax biases against savingand investment, and have flatter tax rates to avoid punishing people who work, save, andproduce more output and income. Eliminating the estate and gift tax removes one layer

11

of tax bias. Another layer is removed by taxing corporate income either at the corporatelevel or at the shareholder level, but not both.16 For full neutrality, the basic income taxbias against saving and investment must be corrected by granting all saving the sametreatment as is given to pensions or IRAs, either by deferring tax on saving until themoney is withdrawn for consumption (as in a regular IRA), or by taxing income beforeit is saved and not taxing the subsequent returns (as in a Roth IRA). The two methodsare equivalent if the tax rate is the same over time (Chart 6). Either method is a boon tosavers. Putting away $1,000 a year from age 20 to 70 at historical stock market yieldsis a saving deferred account yields $400,000, but less than $250,000 under ordinaryincome tax treatment (Chart 7).

President Bush’s 2001 and 2003 tax reforms have gone a long way towardachieving the goal of tax neutrality. They provide for elimination of the estate and gifttax in 2010. They reduce the double taxation of corporate income by taxing dividends andcapital gains at a reduced rate of 15 percent. However, the death tax returns in 2011, andthe tax relief for dividends an capital gains expires at the end of 2008. At the very least,these steps should be made permanent.

The President’s proposed expansion of the neutral treatment of saving in hislifetime saving accounts and pension reforms is a step in the right direction. Theanalogous treatment of investment is to allow immediate expensing of investment insteadof lengthy depreciation. Depreciation understates business costs, overstates income, andovertaxes investment. Chart 8 shows, for example, that the value of the depreciationallowance on a seven year asset at three percent inflation is only 85 cents. The allowedtax cost of a building that must be written of over 39 years is only 37 cents. The erosionof the value of the allowed claims for cost by time and inflation greatly understatesbusiness costs, and the damage is worse the higher the rate of inflation. Assets have tobe able to earn more to cover the added tax. Those that cannot never get built. Workersnever get to work with these assets, and their wages suffer.17 It was a mistake to allowthe 50 percent expensing provision in the 2003 Tax Act to expire at the end of 2004. Thenext chart shows the effect of the 30 percent and 50 percent expensing provisions in the2002 and 2003 tax cuts. They were the major reason why equipment spending andeconomic output bottomed out and then took off in 2003 and 2004 (Chart 9).18

There are several types of neutral tax systems. They include a cash flow or savingdeferred income tax19, a national retail sales tax, a value added tax (VAT)20, a returnsexempt Flat Tax21, or some combination. They all either defer taxes on saving or exemptthe returns to arrive at a saving-consumption neutral tax base. They all eliminate multipletaxation of corporate and individual income and of estates.

An individual cash-flow tax is collected from individuals based on their earningsless their saving, which equals their spending on consumption goods and services. TheFlat Tax uses the Roth IRA method to achieve the same end result. A retail sales tax iscollected by retailers based on the consumption spending of individuals, which is that partof their earnings not devoted to saving. Value added taxes are collected in incrementsthroughout the production process by businesses based on sales less investment expenses;

12


20 (= 160 – 140)

(a third of the interest)Cost to saver of ordinary tax treatment

Illustration assumes 7.2% pre-tax interest rate, 20% tax rate, and 10-year investment.

140160160After-tax spendable balance

0040Tax due on withdrawal

140160200Account after 10 years

Yes, 5.76% reinvestedNo, 7.2% reinvestedNo, 7.2% reinvestedIs interest on inside build-up taxed?

8080100Amount saved

20200Tax on saving

$100$100$100Pretax earnings to be saved

Ordinary Income Tax

Returns ExemptSaving DeferredTax Treatment

Chart 6 Equivalence Of Saving Deferred And Returns Exempt Tax On Saving; Contrast With Ordinary Income Tax


Chart 7Advantage Of Tax Deferred Saving Over Ordinary (Biased) Tax Treatment;Build-up Of $1,000 Saved per Year

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

20 25 30 35 40 45 50 55 60 65 70

Age

Ass

ets

(th

ou

san

ds

of

$)

Saving from age 20 onward, under tax-deferred system and ordinary "double taxation" (assume 7.2% interest rate, 20% tax rate).

TaxDeferred

Ordinary (Biased)

Tax Treatment

Advantage Of Tax Deferred SavingOver Ordinary (Biased) Tax Treatment:

Build-up Of $1,000 Saved per Year


$0.30

$0.37

$0.55

$1.00

39yrs

Assumes a 3.5 percent real discount rate, 3-20 year assets placed in service in first quarter of the year, 27.5 - 39 year assets placed in service in January.

$0.39$0.52$0.60$0.74$0.81$0.86$0.925%

$0.47$0.59$0.67$0.79$0.85$0.89$0.943%

$0.65$0.74$0.80$0.88$0.91$0.94$0.960%Present value of current law write-off of $1 if inflation rate is:

$1.00$1.00$1.00$1.00$1.00$1.00$1.00Present value of first-year write-off of $1 of investment:

27.5 yrs

20yrs

15yrs

10yrs

7yrs

5yrs

3Yrs

Asset lives:

Chart 8 Present Value of Current Law Capital Consumption Allowances per Dollar of Investment Compared to Expensing

(First-Year Write-Off)


800

820

840

860

880

900

920

940

960

980

2000 2001 2002 2003 2004

Quarter

Bill

ion

s o

f D

olla

rs (

2000

$)

Data Source: BEA

Real Private Investment - Equipment And SoftwareAnd 2001, 2002, and 2003 Tax Cuts

2002 Tax Cut, 30% Expensing

2001TaxCut

2003 Tax Cut, 50% Expensing

NIPA Table 5.3.6, line 9

Chart 9

sales less investment equals national income less saving, which again equals the amountspent on consumption of final goods and services. (The Flat Tax may also be thought ofas taxing capital income at the business level with expensing, like the VAT.) In otherwords, these taxes all have the same fundamental tax base.

Some writers make artificial distinctions among saving-consumption neutral taxes,referring to them as consumption taxes if they are of the sales tax or VAT variety, andas saving-deferred or saving-exempt income taxes if they are of the cash flow type or FlatTax, as if to imply that they generate different incentives to save or consume. In fact, thepoint of collection of the taxes does not change their common nature; they are all saving-consumption neutral taxes on people’s incomes (properly defined).

Each of the types of neutral taxes has the potential to accommodate a single lowtax rate on income, and to eliminate the alternative minimum tax and the estate tax. Thesystems all have expensing instead of depreciation (or equivalent non-taxation ofinvestment outlays), and no separate taxation of capital gains. Each is territorial, and cansubstantially reduce the confusing treatment of foreign source income that cripplesAmerican businesses operating abroad.22 Many of the major sources of complexity inthe current tax code would be gone.

Under all of the neutral tax systems, the costs of buying and operating equipment,factories, commercial buildings, and residential real estate, would all be lower. With alower tax hurdle, several trillion dollars of capital investment that is just not sustainableunder current tax law would become possible. Investment would boom for a decade ormore, productivity would rise at a rapid clip, and wages would match the gains.

If the GDP were to be ten percent higher under the new tax regime, it would raiseincomes for middle income families by about $4,000 to $6,000 a year. Everyone wouldgain. Labor would gain most of all. Capital formation boosts productivity and wages.Every dollar of additional GDP made possible by additional capital formation yields about50 cents in higher after-tax wages, about 30 cents in higher federal, state, or local taxrevenue, requires about 15 cents to replace the capital as it wears out, and returns abouta nickel to the savers and investors.

The United States would be a magnet for capital intensive industries furnishinghigher paying jobs. Starting a new business would be far easier, because one couldconcentrate on running the business instead of figuring out tax forms. One could putone’s money to work expanding a business instead of paying insurance premiums to keepthe business in the family in the event of one’s death.

Neutral taxes and visibility. Visibility means that the voting public is well awareof how much the government is costing them. Among the various neutral taxes, thosecollected from individuals are more visible, and those collected by businesses are lessvisible. Some neutral tax plans have recommended very large exempt amounts. Visibilityrequires that, excepting the very poor, as many people as possible pay tax so that, asvoters and consumers of government services, they will be aware of what government

15

costs, and realize that government is not a free good. Neither simplicity nor fairnessshould be used as an excuse for exempting tens of millions of people from tax.

Neutral taxes and simplicity. Neutral taxes are inherently simpler than incometaxes. Picture the current stacks and stacks of tax forms that a parent, a small businessowner, a saver, a retiree, or a low income worker receiving the EITC must fill out. Thinkof the worksheets that govern the taxation of Social Security benefits and the phase-outsof deductions, exemptions, and credits. Think of Schedule D, and of having to list dozensor hundreds of stock trades. Think of the dozens of depreciation schedules and thecomplexity of recapture on Schedule C.

Think about the rules relating to how much you can put into what kind of pensionplan or IRA or education account, when and how much you have to start withdrawing, andwhat happens to you if you miscalculate. Try to figure out the foreign tax credit formwithout computer assistance. Picture doing it all over again if you run afoul of thealternative minimum tax (either the individual AMT, or, if you are a corporate tax officer,the corporate AMT, which taxes corporations more heavily when they are sufferingreduced earnings in a recession, or trying to grow rapidly and increase employment). Tryto plan sensibly for the estate and gift taxes without a tax attorney on your payroll andan insurance broker on call.

Now picture throwing that all into the waste basket. Under neutral taxes, eventhose that are collected from individuals, the filing would be a relative snap. There wouldbe no vast array of credits and exemptions phased in or phased out. There would be nolist of stock trades, no Schedule D, no separate calculation or peculiar taxation of capitalgains. There would not be dozens of different pension arrangements; all saving wouldeither be tax deferred without rules and limits, or would have been done after-tax with notaxation of the subsequent earnings.

There would be no depreciation schedules and no keeping track of different rulesfor different machines and buildings over many years; investment in machinery, buildings,land, resources and research would be deducted dollar for dollar in the year it was made.There would be no foreign income and foreign tax credit offset to compute, and less needfor the IRS to rely on information from foreign banks or businesses to enforce U.S. taxlaw. Tax treaties would relate only to the accurate allocation of costs between parts ofa multinational business.

Picture a tax system in which the individual tax forms fit on two sides of a sheetof paper, nearly all the numbers were provided by one’s employer, bank, broker, or creditcard company, and it only took a day to do.23 Alternatively, picture a Fortune 500business sending in a tax form that weighed one pound instead of one hundred. Picturefifty thousand tax accountants and IRS agents lining up to teach math in grade schoolsacross the country.

Neutral taxes and fairness. It is clear that neutral taxes are fairer than incometaxes, if one understands the nature of income. Income is the payments that people

16

receive for contributing to the production of goods and services by working or makingcapital available. Except in rare cases, people are paid in proportion to how much theyadd to the value of output. If income is proportional to effort and one’s contribution tothe economy, then a flat rate proportional tax, with no tripling up of taxes on saving andinvestment, is arguably the fairest tax.

Kindness and charity urge that the poorest citizens be relieved of the requirementto share in the cost of government. Neutral taxes can be made progressive via rebates (ifthe tax is levied on businesses) or by a personal exempt amount or even multiple tax rates(if levied on individuals), but that should not be carried to excess. Income supportprograms are best handled outside the tax system as explicit payments by federal and stateagencies other than the Treasury.

Nonetheless, neutral or "consumption-based" taxes can be made progressive to thedegree that is deemed desirable. It is not necessary to double or triple tax saving andinvestment to have a progressive tax. That was the main rationale for the income tax inthe 1930s, but we know better today. We can have a fair and charitable neutral tax andstill enjoy the added growth of jobs and income that the correct treatment of saving andinvestment creates.

Neutral taxes encourage investment in education, and encourage highly skilledpeople to keep working and to keep employing others. Spending a hundred thousanddollars on schooling, and losing four to eight years of paychecks, is a major sacrifice.The reward is a higher level of skill and income, compressed into a shorter working life.Graduated tax rates and the lack of a deduction for investment in education penalize suchpeople. A flat or flatter rate neutral tax system would end that discrimination.

Bear in mind that growth generates a higher level of income across the board, andis a good thing for everyone. It is hardly fair if a misguided effort to redistribute the piecauses the pie to shrink, and it is worse than a crime, it is a blunder if such efforts hurtthe poor the most.

Budget and distributional concerns.

Count the gains from growth in determining the budget impact of tax reform. Thepotential for faster growth of jobs and incomes should allay concerns that tax reformmight force a choice between higher short-term budget deficits and tax increases for sometaxpayers.

As saving and investment increase, productivity and the taxpayer’s income willgrow faster for a decade or more and be higher by increasing amounts over time. Whenwe look at how tax reform affects a family or individual worker or taxpayer, it is notenough to apply the new tax code to last year’s income because neither the economy northe taxpayer will behave the same way after tax reform as before.

17

The taxpayer will enjoy lower interest rates on mortgages and student loans as thetax burden on saving is reduced. Although reduced taxes on saving may not instantlylower the tax of a twenty-year-old who has not yet begun to save, it will lower taxes onthat worker as he or she accumulates assets over a working lifetime, and leave that workermany tens of thousands or even hundreds of thousands of dollars better off by age 65, andfar more secure in retirement. Whatever happens the first year, people will enjoy alifetime of benefits from a pro-grow tax reform, and it is the lifetime benefits that matter.

As for the federal budget, there are many benefits, short term and long term.People would immediately have less incentive to shelter their existing income from tax,and the Treasury would see some revenue offset to any net tax reduction even before anyrise in economic activity and income. In addition, of course, national income would growfaster, right from the start. An extra point on the growth rate would add a cumulativeextra half trillion dollars to federal revenues over seven years.

There would also be gains on the spending side of the budget. More peopleworking, and working at higher paying jobs, would men a natural reduction in claims forincome support payments. In light of the great benefits of reform to the economy, thepopulation, and the budget, it would be wise to forge ahead, regardless of the transitorybudget consequences. If the transitory costs to the Treasury are of real concern tolawmakers, they can best be addressed by restraining the growth of federal spending toaccommodate the tax reform.

Conclusion

Tax reform is not about shifting the tax burden to someone else, eliminatingindividual tax filing or making it painless, eliminating millions from the tax rolls,eliminating all deductions, eliminating the IRS, or eliminating competition from foreigncompanies or countries.

Tax reform is not just an indiscriminate "broadening the base and lowering therate."24 It is about getting the tax base right and setting rates that cover the amount ofgovernment that people want to have.

Tax reform is about raising revenue in a manner that does less damage to theeconomy than current law, and that better informs the public what it is paying forgovernment so that voters can make informed decisions about how much governmentactivity they wish to support. Get tax reform right, and we will have a better economyand a better government.

18

Endnotes

1. Stephen J. Entin and Norman B. Ture, "The Inflow Outflow Tax: A Savings Deferred Neutral TaxSystem," 1998, <ftp://ftp.iret.org/pub/InflowOutflowSum.PDF>.

2. Stephen J. Entin, "The Economics of Taxation and The Issue of Tax Reform," IRET Paper, April24-27, 2003, <ftp://ftp.iret.org/pub/EntinNewOrl-2003.PDF>.

3. Stephen J. Entin and Lawrence A. Hunter, "Reforming Taxation: Attributes Of A Good TaxSystem And Principles To Guide Reform," IRET Congressional Advisory, No. 183, January 19, 2005,<ftp://ftp.iret.org/pub/ADVS-183.PDF>.

4. Stephen J. Entin, "Renew Bonus Expensing To Keep Recovery Strong," IRET CongressionalAdvisory, No. 173, May 6, 2004, <ftp://ftp.iret.org/pub/ADVS-173.PDF>.

5. Bruce Bartlett, "The End of Tax Expenditures As We Know Them?" IRET Policy Bulletin, No. 84,June 13, 2001, <ftp://ftp.iret.org/pub/BLTN-84.PDF>.

6. Stephen J. Entin, "Tax Incidence, Tax Burden, And Tax Shifting: Who Really Pays The Tax?" IRET Policy Bulletin, No 88, September 10, 2004, <ftp://ftp.iret.org/pub/BLTN-88.PDF>.

7. Michael Schuyler, "Phase-Outs Are Bad Tax Policy," IRET Policy Bulletin, No. 71, January 16,1998, <ftp://ftp.iret.org/pub/BLTN-71.PDF>.

8. Norman B. Ture, "Taxes and the Good Society," Lecture by Norman B. Ture, Delivered at Centerfor Economic and Policy Education, Saint Vincent College, September 13, 1995,<ftp://ftp.iret.org/pub/TaxesGoodSoc.PDF>.

9. See note 11.

10. Bruce Bartlett, The End of Tax Expenditures As We Know Them?, op. cit.

11. Such issues were not considered in 1986, and the results were not good. The Tax Reform Act of1986 was often described as "broadening the base and lowering the rates." Although this is sometimesoffered as a definition of a sound tax reform, it misses many basic points. In fact, the 1986 Act was amajor disappointment. It lowered personal tax rates at the margin, which was a good step towardeconomic efficiency. However, it sharply raised tax rates, at the margin, on new saving and investment,which increased the income tax bias against those activities. It did so, in the guise of base broadening, byremoving provisions that mitigated the multiple layers of tax imposed on income from saving and invest-ment. The Act eliminated the investment tax credit, lengthened asset lives for cost recovery purposes,ended the capital gains differential, imposed or tightened income and contribution limits on tax deferredretirement savings plans, and introduced passive loss rules on real estate that depressed returns in thatsector for investors who were not active managers of their properties. The minor efficiency gains thatcame from canceling a few peculiar tax breaks for certain other activities in no way made up for theseacross-the-board increases in the taxation of capital.

In effect, the Tax Reform Act of 1986 moved the hybrid tax system in the direction of a purerbroad-based income tax. The Act paved the way for the stock market crash of October 1987, and led toweakness in investment in plant, equipment, and real estate that, along with two payroll tax increases in1988 and 1990, set the stage for the recession of 1991-92. The 1986 Act also removed several million

19








ftp://ftp.iret.org/pub/TaxesGoodSoc.PDF

people from the income tax rolls, making them less concerned about the cost of government and lessinterested in controlling federal spending and tax rates in the future.

12. This framework owes much to the work of IRET’s founder, the late Norman B. Ture. See hispapers: "Taxes and the Good Society," op. cit.; "Restructuring The Federal Tax System" IRET PolicyBulletin, No. 65, December 15, 1995, <ftp://ftp.iret.org/pub/ BLTN-65.PDF>; and "Federal Tax Policy andthe U.S. Economy: Policy Options for Improving Both," March 13, 1997,<ftp://ftp.iret.org/pub/FedTaxPol-Improv.PDF>. For an overview of a model tax system that Dr. Tureproposed based on these principles, see Stephen J. Entin and Norman B. Ture, "The Inflow Outflow Tax —A Saving-Deferred Neutral Tax System," op. cit..

13. For more on the biases against saving in the current income tax, see Stephen J. Entin, "TheEconomics of Taxation and the Issue of Tax Reform," <ftp://ftp.iret.org/pub/EntinNewOrl-2003.PDF>;Stephen J. Entin, "Fixing The Saving Problem: How The Tax System Depresses Saving, And What To DoAbout It," IRET Policy Bulletin, No. 85, August 6, 2001, p. 15 ff, <ftp://ftp.iret.org/pub/BLTN-85.PDF>.Also see David F. Bradford and the U.S. Treasury Tax Policy Staff, Blueprints for Basic Tax Reform, 2nded., revised (Arlington, VA: Tax Analysts, 1985).

14. Any justification of the comprehensive or broad-based income tax and the additional corporate anddeath duties must rely on significant non-economic social benefits, because these taxes impose higheconomic costs, including reduced incomes across the board. The usual social benefit assumed for theincome tax is that it may be used to reduce income inequality. However, redistribution lowers totalincome, especially labor income, and the process can hurt those it is designed to help. Early advocates ofusing the broad-based income tax for redistribution, such as Professor Henry C. Simons, acknowledgedsome of the costs.

Simons admitted that the income tax is not economically ideal. He reasoned that, since the richsave more than the poor, taxing saving more heavily than consumption would be "progressive". Simonsalso favored making the marginal tax rate structure graduated (higher tax rates imposed on incrementaltaxable income as it exceeds specified levels) to further increase the progressivity of the system. The pureSimons definition of income did not allow for a corporate tax in addition to the individual income tax,however, because that would have been an additional layer of double taxation.

Professor Simons was well aware that the twin distortions of the tax base and the rate structureinherent in the income tax could lead to a drop in saving, investment, and national income. In his magnumopus, Personal Income Taxation, (Chicago, IL: University of Chicago Press, 1938), Simons wrote:

The case for drastic progression in taxation must be rested on the case against inequality— on the ethical or aesthetic judgment that the prevailing distribution of wealth andincome reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely...

The degree of progression in a tax system may also affect production and the size of thenational income available for distribution. In fact, it is reasonable to expect that everygain, through taxation, in better distribution will be accompanied by some loss inproduction...

[I]f reduction in the degree of inequality is a good, then the optimum degree ofprogression must involve a distinctly adverse effect upon the size of the national income...(Simons, pp. 18-20.)

Simons took seriously the possibility that saving and investment would suffer from his policyprescription:

20

ftp://ftp.iret.org/pub/ BLTN-65.PDF

ftp://ftp.iret.org/pub/FedTaxPol-Improv.PDF



With respect to capital accumulation, ...the consequences are certain to be significantlyadverse... [I]t is hardly questionable that increasing progression is inimical to saving andaccumulation... That the net effect will be increased consumption ... hardly admits ofdoubt." (Simons, pp. 21-23.)

Simons’s remedy was not to do away with progressivity, but to offset its effect on saving byrunning federal budget surpluses. The assumption that the government virtuously would run large budgetsurpluses to make up for the anti-growth consequences of a biased and progressive tax system has provento be utterly naive. Furthermore, a budget surplus cannot make up for the adverse effects that highcorporate or individual tax rates and unfriendly capital cost recovery allowances have on the present valueof after-tax cash flow from an investment, a calculation that any business school graduate will undertake indeciding on the feasibility of an investment project. Thus, even an offsetting budget surplus would notprevent a reduction in the equilibrium capital stock from a reduction in the marginal return on investment.

Professor Alfred Marshall, who bowed to the general acceptance of progressivity, nonethelessfavored a more neutral graduated tax on consumption over a graduated tax on income: "[T]here is ageneral agreement that a system of taxation should be adjusted, in more or less steep graduation, topeople’s incomes: or better still to their expenditures. For that part of a man’s income, which he saves,contributes again to the Exchequer until it is consumed by expenditure." (Alfred Marshall, Principles ofEconomics, Eighth Edition (1920), Philadelphia, PA, Porcupine Press, reprinted 1982, p. 661.)

As Marshall pointed out, one does not need to adopt a non-neutral income tax to achieveprogressivity. Saving-consumption neutral taxes can be made progressive as well. In fact, it is notnecessary to have graduated tax rates to achieve progressivity. A tax which exempts some amount ofincome at the bottom, and imposes a flat marginal tax rate on income above that amount, is progressive,because the average tax rate will rise with income. A graduated consumption-based tax is not aseconomically efficient as a flat rate consumption-based tax, because it increases the tax penalty at themargin the more productive an individual becomes and the more effort he or she makes. Nonetheless, it isfar more efficient than a graduated income tax.

15. Several studies in the economic literature illustrate that neutral treatment of capital income wouldraise the after-tax income of labor, in present value terms, even if labor must pick up the tab for the losttax revenue. That is, a tax on capital is effectively shifted to labor. For a further discussion of tax shiftingand the literature on optimal taxation of capital, see Stephen J. Entin, Tax Incidence, Tax Burden, And TaxShifting: Who Really Pays The Tax?, op. cit.

16. The Treasury issued a report on corporate individual tax integration in 1991, and there is a longliterature on these mechanisms. Most other developed countries use one approach or another to mitigatedouble taxation of corporate income, and have lower corporate tax rates as well.

17. For a further discussion of the merits of expensing, see Entin, The Economics of Taxation and theIssue of Tax Reform, op. cit., <ftp://ftp.iret.org/pub/ EntinNewOrl-2003.PDF>. Also David Bradford,Blueprints for Basic Tax Reform, op. cit..

18. See Stephen J. Entin, "Renew Bonus Expensing To Keep Recovery Strong," IRET CongressionalAdvisory, No.173, May 6, 2004, <ftp://ftp.iret.org/pub/ADVS-173.PDF>.

19. A tax on income less net saving, in which all saving is tax deferred in the manner that current lawallows for limited amounts of saving in an ordinary IRA, 401(k), or pension. This type of tax is alsocalled an inflow-outflow tax, a consumed income tax, an individual cash flow tax, or an expenditure tax.

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ftp://ftp.iret.org/pub/ EntinNewOrl-2003.PDF


For a full description, see The Inflow-Outflow Tax, op. cit., <ftp://ftp.iret.org/pub/InflowOutflowSum.PDF>.

20. Value added taxes include European style credit invoice method VATs, goods and services taxes orGSTs (as in Canada and Australia), subtraction method VATs, and business transfer taxes.

21. A returns exempt tax does not allow a deduction for or deferral of current saving, which must bedone on an after-tax basis, but it does not subsequently tax the returns on that after-tax saving. It is themethod used for Roth IRAs.

22. All the major saving-consumption neutral taxes would lead to international tax simplificationbecause all are territorial. That is, they are imposed on economic activity within the United States, and noton economic activity conducted by U.S. residents elsewhere in the world. The present global income taxrequires U.S. residents to report income from around the world, and then to file for a foreign tax credit toavoid double taxation. Moving to a territorial system, not only for businesses but for individuals as well,would provide great simplification for taxpayers and would reduce administrative and enforcement costs forthe IRS with little revenue consequence. It would also greatly enhance the competitiveness of U.S.-basedmultinational firms that must compete with foreign firms whose home countries have territorial regimes andlower corporate tax rates than the United States. It would be expected to raise exports of intermediategoods and services of multinational businesses to their affiliates abroad, and lead to more demand for theresearch and management functions of the U.S. parents.

Sales taxes and VATs are generally imposed on imports and remitted or not levied on exports.This feature is called border adjustability. The border-adjustable form is natural because sales taxes (andthe final layer of the VAT) are collected at the point of final sale to consumers. With border adjustment,any purchase, whether domestic or foreign in origin, triggers the same tax at the cash register. Consumed-income taxes and the Flat Tax are not explicitly border adjustable, because they are collected fromindividuals as they earn. However, these taxes fall on income before it is used for consumption, and so thetax falls on income used to buy a domestic good or an import. The tax is not levied on foreigners buyingU.S. exports. These taxes may be thought of as implicitly border adjustable. Border adjustment andterritoriality are different concepts.

23. A simple neutral individual cash flow tax might arguably be considered the optimal tax system. Anexample is the Inflow-Outflow Tax expounded by the late Norman B. Ture at the Institute for Research onthe Economics of Taxation. It is levied only on individuals, and is therefore the most visible tax system.In it, people would defer tax on saving and investment (including tuition invested in human capital), anddeduct any income they transfer to others (as gifts or as taxes). Thus, charitable gifts, payroll taxes, andtaxes paid to state and local governments would be deductible (and recipients of transfers would report thereceipts as taxable income if it exceeded exempt amounts).

Saving would be deducted from taxable income. Withdrawals from saving would be added toincome. One’s bank or broker would give one the required amount to enter on the tax form. There wouldbe an exempt amount to protect the poor, and, ideally, a single (flat) marginal tax rate on all other income,which would minimize all other distortions of economic activity. Investment in inventories, equipment,and buildings for one’s business would simply be expensed. The I-O tax would fall on virtually the sametax base as a national retail sales tax, but would be more visible to the taxpayer/voter, and would do abetter job of "costing out" government. See The Inflow-Outflow Tax, op. cit.,<ftp://ftp.iret.org/pub/InflowOutflowSum.PDF>.

24. We do not want another Tax Reform Act of 1986. See note 11 and Reforming Taxation: Attributes ofa Good Tax System and Principles to Guide Reform op. cit., <ftp://ftp.iret.org/pub/ADVS-183.PDF>,

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